Rebalancing bonus

What Is Rebalancing Bonus?

The rebalancing bonus, a concept within portfolio management, refers to the potential for a portfolio's actual expected return to exceed the simple weighted average of its underlying asset returns, specifically due to the systematic process of portfolio rebalancing. This phenomenon typically arises when rebalancing occurs between assets that have similar long-term returns but exhibit different patterns of volatility and low correlation with each other. By regularly adjusting asset weights back to a target asset allocation, an investor inherently sells assets that have performed well (grown above their target weight) and buys assets that have underperformed (fallen below their target weight), effectively engaging in a "buy low, sell high" dynamic without requiring market timing ability.

History and Origin

The concept of the rebalancing bonus gained prominence through the work of financial author and investment advisor William Bernstein. In his paper, "The Rebalancing Bonus," Bernstein articulated how this excess return can materialize, particularly when rebalancing between highly volatile and lowly correlated assets that have comparable long-term average returns.¹⁸ His work provided a theoretical framework and empirical observations for this phenomenon, illustrating how a disciplined rebalancing approach can capture returns from market movements that diverge from initial allocations.¹⁷ While the practical benefits and magnitude of the rebalancing bonus are subject to ongoing discussion, Bernstein's contributions helped solidify its place in discussions around advanced investment strategy.

Key Takeaways

• The rebalancing bonus describes the potential for portfolio returns to exceed the average weighted returns of its components through disciplined rebalancing.
• It is most pronounced when rebalancing between assets with high volatility and low correlation that are expected to have similar long-term returns.
• Rebalancing involves systematically selling winning assets and buying losing assets to maintain a target asset allocation.
• While it can enhance returns, the primary objective of rebalancing is often to control risk tolerance and maintain a desired risk profile.
• The actual realization and magnitude of a rebalancing bonus can be influenced by transaction costs and market conditions.

Interpreting the Rebalancing Bonus

Interpreting the rebalancing bonus involves understanding that it is not a guaranteed outcome but rather a potential benefit derived from a structured portfolio management approach. The bonus is generally believed to be higher when the assets within a portfolio exhibit significant individual price fluctuations (high volatility) and tend to move independently of each other (low correlation).¹⁶ In such scenarios, rebalancing allows a portfolio to benefit from the natural reversion of asset prices to their long-term means. It contributes to enhancing risk-adjusted returns, as it aims to reduce overall portfolio volatility while potentially adding a modest return premium. However, if assets consistently diverge in performance over long periods, rebalancing away from the higher-performing asset into the lower-performing one may reduce overall returns, though it maintains the target risk profile.¹⁵

Hypothetical Example

Consider a hypothetical portfolio with an initial asset allocation of 50% in Asset A and 50% in Asset B. Both assets have an average long-term expected return of 8%, but their annual returns are highly volatile and negatively correlated.

• Year 1:

  • Asset A returns +30%
  • Asset B returns -10%
  • A $10,000 portfolio ($5,000 in each) would become: Asset A: $5,000 * 1.30 = $6,500; Asset B: $5,000 * 0.90 = $4,500. Total portfolio value: $11,000.
  • The portfolio weight has shifted to approximately 59% Asset A ($6,500/$11,000) and 41% Asset B ($4,500/$11,000).

• Rebalancing at Year 1 end:

  • To restore the 50/50 allocation, $900 ($6,500 - $5,500) of Asset A is sold, and $900 is used to buy Asset B ($4,500 + $900 = $5,400). (Slight rounding difference due to simplicity: actual target is $11,000 * 0.50 = $5,500 for each).
  • New portfolio: $5,500 in Asset A, $5,500 in Asset B.

• Year 2:

  • Asset A returns -10%
  • Asset B returns +30%
  • Rebalanced portfolio: Asset A: $5,500 * 0.90 = $4,950; Asset B: $5,500 * 1.30 = $7,150. Total portfolio value: $12,100.

In this simplified scenario, the act of portfolio rebalancing allowed the investor to sell high and buy low, benefiting from the reversal of performance between the two assets. If the portfolio had not been rebalanced, its composition would have become heavily skewed, and it might not have fully captured the subsequent rebound in the underperforming asset.

Practical Applications

The rebalancing bonus is a consideration in the ongoing management of diversified investment portfolios. It highlights a potential advantage of systematic portfolio rebalancing over a pure buy-and-hold strategy, particularly for portfolios composed of assets with differing market volatility and low correlation. This is especially relevant in contexts where investors aim to maintain a consistent risk tolerance over time.

For instance, academic research and practical analyses suggest that rebalancing can enhance risk-adjusted returns for certain asset classes, such as equities and commodities, due to their inherent volatility.¹⁴ However, the effectiveness can vary, with bonds and real estate investment trusts (REITs) potentially showing a less beneficial or even detrimental relationship with frequent rebalancing.¹³ The concept is often discussed in the context of Modern Portfolio Theory, which emphasizes the importance of managing risk and return through diversification and strategic asset allocation.

Limitations and Criticisms

While the rebalancing bonus suggests a compelling reason for active portfolio management, it is not without limitations and criticisms. One primary critique centers on the practical implementation, specifically the impact of transaction costs and potential capital gains taxes triggered by frequent buying and selling.¹² These costs can erode any theoretical rebalancing bonus, especially for smaller portfolios or those with high-turnover assets.

Furthermore, some research argues that the perceived advantages of rebalancing are often misattributed, confusing "rebalancing returns" with "diversification returns" that can be achieved by both rebalanced and unrebalanced portfolios.¹¹ Critics also point out that in periods where one asset class consistently outperforms another over a long horizon, a disciplined rebalancing strategy (selling the winner to buy the loser) may actually reduce overall returns compared to a buy-and-hold strategy that lets winners run.⁸, ⁹, ¹⁰ The debate often highlights that while rebalancing effectively controls portfolio risk by preventing allocations from drifting, its ability to consistently boost absolute returns is less certain and highly dependent on specific market conditions and asset characteristics.⁶, ⁷

Rebalancing Bonus vs. Diversification Return

The rebalancing bonus is often confused with or seen as a component of the diversification return. While both relate to the benefits of holding a diversified portfolio, they describe distinct aspects. The rebalancing bonus specifically refers to the excess return generated by the mechanical process of restoring target asset weights, effectively profiting from the differential performance and mean reversion of individual assets within the portfolio. It requires active rebalancing. In contrast, diversification return (also known as the "covariance return" or "volatility harvesting") is the mathematical outcome of combining multiple volatile assets that do not move in perfect lockstep, regardless of whether the portfolio is rebalanced or not. It captures the benefit of reduced portfolio volatility due to the imperfect correlation between assets. While rebalancing can help capture and maximize the diversification return by maintaining desired asset weights, the diversification return itself is an inherent property of a multi-asset portfolio.

FAQs

Is the rebalancing bonus guaranteed?

No, the rebalancing bonus is not guaranteed. Its realization depends on various factors, including the volatility and correlation of the assets in the portfolio, the frequency of rebalancing, and prevailing market conditions.⁵

How does volatility affect the rebalancing bonus?

Higher individual asset volatility, especially when coupled with low or negative correlation between assets, tends to increase the potential for a rebalancing bonus. This is because greater price swings create more opportunities for the "buy low, sell high" dynamic inherent in portfolio rebalancing.⁴

Does the rebalancing bonus always lead to higher returns than a buy-and-hold strategy?

Not necessarily. While rebalancing can enhance risk-adjusted returns and maintain a consistent risk tolerance, if one asset class consistently outperforms others over a long period, a buy-and-hold strategy that allows the winning asset to grow may result in higher absolute returns, albeit with potentially higher risk as the portfolio allocation drifts.³

What are the main downsides of pursuing a rebalancing bonus?

The primary downsides include transaction costs associated with frequent trades and potential tax implications from realizing capital gains. These costs can diminish or even negate any theoretical rebalancing bonus.²

How does correlation impact the rebalancing bonus?

Low or negative correlation between assets is crucial for maximizing the rebalancing bonus. When assets move independently or inversely, rebalancing creates more opportunities to sell assets that have risen and buy assets that have fallen, effectively capitalizing on their divergent paths.¹