Measuring Volatility Pumping Benefits in Equity Markets

Summary:

It has been argued that portfolio rebalancing, defined as the simple act of resetting portfolio weights back to their original weights, can be a source of additional performance. This additional performance is known as the rebalancing premium, also sometimes referred to 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 paper is to provide a thorough numerical and empirical analysis of the volatility pumping effect in equity markets and to examine the conditions under which it can be maximised. Our 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 Fama-French-Carhart four-factor model, we find that after controlling for factor exposures, the outperformance of the rebalanced strategy with respect to the corresponding buy-and-hold strategy remains substantial at an annualised level above 100 basis points over a 5 year time-horizon for stocks in the S&P 500 universe. We also find that size, value, momentum and volatility are sorting characteristics which 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. We 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.