In a wide-ranging article about fundamentally-weighted indexes, Chris Brightman of Research Affiliates gets into some of the additional ways that a portfolio can be optimized. One of those optimization tools is being mindful about how frequently you’re rebalancing.
Chris makes the important point that adjusting your frequency of rebalancing really won’t have much of an impact in terms of volatility and returns – but it can have a big impact in terms of trading costs and taxation. Note the orange line in the below chart indicating turnover.
In short, when you rebalance and how frequently doesn’t matter, even if it really does matter.
Have I lost you?
Another source of unproductive turnover is too-frequent rebalancing. The optimal frequency of rebalancing is a trade-off among several factors: the opportunity to profit from long-term mean reversion of stock prices, the cost of trading against short-term price momentum, and the cost of turnover. Figure 2 displays the impact of varying the frequency of rebalancing on simulated return, volatility, and turnover.
By squinting at Figure 2, one can detect slight increases in return and declines in volatility (left scale) from moving toward less frequent rebalancing intervals. This result is consistent with the widely observed pattern of short-term momentum and long-term mean reversion in stock prices; frequent rebalancing is like swimming upstream against stock price momentum. But the magnitude of these differences in return and volatility are not practically meaningful.
The decline in turnover displayed on the right scale is significant. Moving from monthly to annual rebalancing reduces average annual turnover from approximately 36% to about 11%. For this reason, the RAFI Fundamental Index strategy is rebalanced only annually (even when this annual rebalance is staggered over four quarters).
Unless you’re investing in a tax-free vehicle like a pension or charitable foundation account, turnover will affect real returns – even if its impact doesn’t show up in raw performance data. This is an important consideration for all serious portfolio managers.