Many investors may be surprised to learn that a mechanical rebalancing strategy, such as a monthly or quarterly reallocation to 60-40 portfolio, is an active strategy. Winning asset classes are sold and losers are bought. In trending markets, this could lead to larger drawdowns than a buy-and-hold strategy. We show that these drawdowns induced by naive rebalancing could be mitigated. One potential alternative is an allocation to a trend-following strategy.
Our analysis shows that this strategy does well in periods of extreme negative returns and counterbalances a rebalancing strategy. The second alternative we call strategic or smart rebalancing, which uses trend-following signals to time the rebalancing, i.e., without a direct allocation to a trend-following strategy. For example, if the trend-following model suggests that stock markets are in a negative trend, rebalancing is delayed.
Many investors don’t realize that a mechanical rebalancing strategy, such as a monthly or quarterly reallocation towards fixed portfolio weights, is an active strategy. Winning asset classes are sold and losers are bought. During crises, when markets are often trending, this could lead to larger drawdowns than a buy-and-hold strategy. We show that these drawdowns induced by naïve rebalancing could be mitigated, taking the popular 60-40 stock-bond portfolio as our use case.
One alternative is an allocation to a trend-following strategy. This type of strategy has the potential to do better in periods of extreme negative returns and help counterbalance the rebalancing strategy. The second alternative we call strategic rebalancing, which uses smart rebalancing timing based on trend-following signals – without a direct allocation to a trend-following strategy. For example, if the trend-following model suggests that stock markets are in a negative trend, rebalancing is delayed.
Of course, a pure buy-and-hold portfolio has the drawback that the asset mix tends to drift over time and, as such, is untenable for investors who seek diversification. For a US stock-bond portfolio, an initial 60% of capital allocated to stocks in 1927 drifts to a 76% allocation by 1929, a 32% allocation by 1932, and a level close to 100% over time, as stocks tend to outperform bonds over the long run (Figure 1).
Figure 1: Allocation to Stocks for an Initial Capital Weighted 60-40 Stock-Bond Portfolio
Source: Federal Reserve, Kenneth French website, Global Financial Data; Between January 1927 and December 2017.
However, a stock-bond portfolio that regularly rebalances tends to underperform a buy-and-hold portfolio at times of continued outperformance of one of the assets. Intuitively, this is because rebalancing means selling (relative) winners, and if winners continue to outperform, that detracts from performance.
COMPARING REBALANCED AND BUY-AND-HOLD PORTFOLIO RETURNS
As stocks typically have more volatile returns than bonds, relative returns tend to be driven by stocks. Hence, of particular interest are episodes with continued negative (absolute and relative) stock performance, such as the 2007-2009 global financial crisis. In Figure 2, we contrast the monthly-rebalanced and buy-and-hold cumulative performance over the financial crisis period, where both start with an initial 60-40 stock-bond capital allocation.1 The maximum drawdown of the monthly-rebalanced portfolio is 1.2 times (or 5 percentage points) worse than that of the buy-and-hold portfolio, right at the time when financial markets turmoil is greatest.
Figure 2: Performance Monthly-Rebalanced and Buy-and-Hold Portfolios During the Global Financial Crisis
Source: Federal Reserve, Kenneth French website, Global Financial Data; Between January 2007 and December 2009.
In earlier work, Granger et al. (2014) formally show that rebalancing is similar to starting with a buy-and-hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets.2 The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns.
ALLOCATION TO TREND
Indeed, our empirical analysis shows that time-series momentum (or trend) strategies, applied to futures on the same stock and bond markets, may act as natural complements to a rebalanced portfolio. This is because the trend payoff tends to mimic that of a long straddle option position, or exhibits positive convexity, see, e.g., Martin and Zou (2012)3 and Hamill, Rattray, and Van Hemert (2016).4
Our main analysis is for the 1960-2017 period, which includes the bond bear market of the 1960 and 1970s, but omits the different bond regime before 1960.5 We evaluate how 1-, 3-, and 12-month trend strategies perform during the five worst drawdowns for the 60-40 stock-bond portfolio. In our analysis, allocating 10% to a trend strategy and 90% to a 60-40 monthly-rebalanced portfolio improves the average drawdown by about 5 percentage points, compared to a 100% allocation to a 60-40 monthly rebalanced portfolio. The trend allocation has no adverse impact on the average return over our sample period. That is, while one would normally expect a drag on the overall (long-term) performance when allocating to a defensive strategy, in our sample, the trend-following premium earned offsets the cost (or insurance premium) paid.6
STRATEGIC REBALANCING VERSUS A DIRECT ALLOCATION TO TREND
An alternative to a trend allocation is strategically timing and sizing rebalancing trades, which we label strategic rebalancing. We first consider a range of popular heuristic rules; varying the rebalancing frequency, using thresholds, and trading only partially back to the 60-40 asset mix. Such heuristic rules reduce the average maximum drawdown level for the five crises considered by up to 1 percentage point. However, using strategic rebalancing rules based on either the past stock or past stock-bond relative returns gives improvements of 2 to 3 percentage points.
In Figure 3, we show the impact on the drawdown level of the types of trend exposures we discussed. Concretely: a 10% allocation to a 12-month stocks and bonds (equal risk) trend strategy and a strategic rebalancing rule to delay rebalancing if the 12-month stock-bond spread trend is negative. The main takeaway is that either a direct allocation to a trend strategy or using trend signals as a basis of a rebalancing rule tends to reduce the drawdown materially. The performance around Black Monday is the only exception here in case of an allocation to trend (less so for the strategic rebalancing rule).
Figure 3: Impact of Adding a Trend Exposure on the Portfolio Drawdown Level
Source: Federal Reserve, Kenneth French website, Global Financial Data; Between January 1960 and December 2017.
A pure buy-and-hold portfolio may be untenable for many investors as it leads to a highly concentrated, undiversified portfolio. However, a 60-40 stock-bond portfolio that rebalances every month to the 60:40 target ratio loses several percentage points more than a buy-and-hold portfolio during periods of continued stock market drawdowns.
Negative convexity induced by rebalancing could be effectively countered with a trend exposure, which exhibits positive convexity and can be either implemented as a direct allocation to a trend investment product or with a strategic trend-based rebalancing rule.
While our focus is on countering the negative convexity induced by rebalancing, other considerations matter in practice as well. For example, investors can also use monthly in- and out-flows to move back toward the target asset mix. For taxable investors, rebalancing using income has the added potential benefit that no assets need to be sold, which can be tax efficient; see Colleen, Kinniry, and Zilbering (2010).7
Finally, a stock-bond trend exposure is just one way to mitigate drawdowns at times of continued stock market losses. An investor has more arrows in her quiver. A good starting point is a more diversified portfolio that includes more asset classes and has an international exposure. An allocation to a broader trend strategy that benefits from trends in other macro assets at times of equity market distress may further dampen equity market losses; see Hamill, Rattray, and Van Hemert (2016). And Harvey et al. (2018) study volatility targeting and show that it can help manage the risk of a 60-40 stock-bond portfolio.8
1. For our empirical analysis, we use we use monthly value-weighted returns of firms listed on the NYSE, AMEX, and NASDAQ from Kenneth French's website. For bonds, we use US Treasury bond data from the Federal Reserve.
2. Granger, N., D. Greenig, C.R. Harvey, S. Rattray, D. Zou (2014), “Rebalancing risk”, SSRN working paper: https://ssrn.com/abstract=2488552.
3. Martin, R. and D. Zou. (2012), “Momentum trading: ‘skews me”, Risk, 25(8), 52-57.
4. Hamill, C., S. Rattray, and O. Van Hemert (2016), “Trend following: equity and bond crisis alpha”, SSRN working paper https://ssrn.com/abstract=2831926.
5. See also Harvey et al. (2018) for a discussion on the different US bond regimes.
6. We find that the performance of trend strategies is consistent over time, not driven by any particular sub-period.
7. Colleen, J., F. Kinniry, and Y. Zilbering (2010) “Best practices for portfolio rebalancing”, Vanguard working paper.
8. Harvey, C. R., E. Hoyle, Russell Korgaonkar, S. Rattray, M. Sargaison, and O. Van Hemert (2018), “The impact of volatility targeting”, Journal of Portfolio Management, 45(1), 14-33.
Download full article
Opinions expressed are those of the author and may not be shared by all personnel of Man Group plc (‘Man’). These opinions are subject to change without notice, are for information purposes only and do not constitute an offer or invitation to make an investment in any financial instrument or in any product to which the Company and/or its affiliates provides investment advisory or any other financial services. Any organisations, financial instrument or products described in this material are mentioned for reference purposes only which should not be considered a recommendation for their purchase or sale. Neither the Company nor the authors shall be liable to any person for any action taken on the basis of the information provided. Some statements contained in this material concerning goals, strategies, outlook or other non-historical matters may be forward-looking statements and are based on current indicators and expectations. These forward-looking statements speak only as of the date on which they are made, and the Company undertakes no obligation to update or revise any forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements. The Company and/or its affiliates may or may not have a position in any financial instrument mentioned and may or may not be actively trading in any such securities. This material is proprietary information of the Company and its affiliates and may not be reproduced or otherwise disseminated in whole or in part without prior written consent from the Company. The Company believes the content to be accurate. However accuracy is not warranted or guaranteed. The Company does not assume any liability in the case of incorrectly reported or incomplete information. Unless stated otherwise all information is provided by the Company. Past performance is not indicative of future results.