Why rebalancing is crucial in rule-based investing

Investors have spent decades hunting down ways to profit from stock market anomalies. But in recent years the idea of systematically skimming premiums from the stocks in the market most exposed to factors like size, value, momentum, quality and low volatility has reached new levels of sophistication. So-called 'smart beta' funds now focus entirely on squeezing profits out of factors like these. Look closer at their strategies and you'll see that they put considerable emphasis on routine rebalancing. For anyone following a rule-based, factor-focused strategy, it's worth knowing why this sort of portfolio management matters.

A matter of factor

First, a bit of background. Twenty-five years ago Eugene Fama and Ken French created a ground-breaking model of stock market returns using just three factors. Their research especially pinpointed size (small caps beat large caps) and value (cheap stocks beat expensive stocks) as consistent sources of outperformance. Since then further strides to improve the understanding of stock returns have been made by luminaries like Carhart, Asness, Lakonishok and others… with proof building that the following additional factors are highly correlated with future stock returns:

• momentum (the tendency for price trends to persist for between three months and a year)
• quality (firms with strong finances and robust business models beat weak, deteriorating junk stocks)
• low volatility (lower risk stocks have higher expected returns)

A number of the academics that originally researched these and other factors have since crossed into industry. They're either advising multi-million dollar funds, or running them. And one of the debates that they've been having in recent years is about the influence that rebalancing has on a factor-focused portfolio.

What rebalancing means

Rebalancing involves tweaking a portfolio so that it's weighted and diversified according to the original investment plan. Over time, even if you do nothing with a portfolio, its initial weights will eventually get out of whack as stock prices rise and fall. Traditionally, investors have been warned about this kind of drift because of the risk of being overexposed to individual positions.

In a factor-focused strategy - particularly one that uses value and momentum - there is an inherent risk of style drift without rebalancing. What that means is that value stocks that rise in price will eventually cease to offer the value premium any more. Likewise, momentum, which may last for up to a year, will eventually peter out. With the portfolio no longer exposed to those factors, it's clear why regular rebalancing is needed.

Is rebalancing a source of returns?

Some analysis of smart beta investing suggests that it's actually the rebalancing itself that drives the return in these strategies. Adrian Banner of asset management firm Intech, suggests that regular rebalancing 'accidentally' capitalises on something called “volatility harvesting". In simple terms, the implication is that regular rebalancing captures a return from the natural price volatility of these stocks rather than the intended factor.

But David Blitz, the Head of Quantitative Equities Research at investment firm Robeco, doesn't agree. He believes that it's the other way around: factor premiums actually explain any positive returns from rebalancing. Among the arguments to support his case, he points out that the strong performance of portfolios with attractive factors is mirrored by underperformance of portfolios with unattractive factors (expensive or poor momentum stocks) - suggesting that it's the factors driving the return, not the rebalancing.

Either way, there is general agreement that rebalancing is crucial in factor investing. But when deciding on when to do it, it's important to consider the nature of those factors. For instance, in the case of value, the wait for a price re-rating (mean reversion) can take years. But with momentum, the returns have been shown to occur much sooner. And as Chris Brightman at smart beta firm Research Affiliates observes: “...frequent rebalancing is like swimming upstream against stock price momentum."

For this reason, many agree that a one year rebalancing schedule is a useful starting point, and even then only trading those positions that have moved beyond a certain threshold (we look closer at this here). In fact, analysis by Research Affiliates shows that there is little to gain from rebalancing quarterly rather than annually. It turns out that quarterly rebalancing simply racks up portfolio churn and trading costs, exacerbating the regular costs of rebalancing that are determined by the size of the portfolio, personal tax and spreads.

So the message is that rebalancing is a vital component of a factor-focused investing strategy - but not with a frequency that kills those factor premiums and ends up being too costly.

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