Too few pension fund staff professionals are rebalancing to target asset allocations. Many have no system for rebalancing regularly and systematically. Even those who do sometimes have surprisingly vague policies, and acting on them is unnecessarily difficult. As a result, many are losing out on the benefits that derive from regularly realigning their portfolios to ensure the original balance between asset classes remains.
Those who implement an efficient rebalancing strategy are simply following a policy drawn up in advance. They are not trying to forecast where the market is going. Nor are they taking a bet that they hope will pay off. Yet their rebalancing strategy effectively "sells high and buys low" by moving money from assets that have grown to those that have fallen.
Without a clear rebalancing policy, the asset allocation is unanchored and unmanaged. This approach introduces unnecessary and unrewarded risk.
The good news is that new developments have made it easier to rebalance effectively.
Among them is improved technology, which allows for more cost-effective policy implementation. Data are now available more quickly - albeit unaudited - from custodians, enabling plan staff to know the state of their assets more precisely.
Increased availability and greater liquidity of numerous futures contracts around the world also make it easier for plan staff to maintain exposure to the market while moving their assets.
Several steps will help pension sponsor staff to ensure their rebalancing is effective.
First, they should define a policy. Such a policy should include specific target ranges that would prompt rebalancing. It should outline action in a variety of situations, too, such as when an asset breaches its upper limit but none breaches the lower. In this case, staff might, for example, adopt a rule of moving the excess to whichever other asset class is most underweight.
The policy should also address whether money should be moved from all managers in an overweight asset class, resulting in a greater number of transactions, or from just one. Rebalancing policy can also be integrated with a cash equitization program. Many institutional investors choose to deal with non-strategic frictional cash by applying a futures overlay. This maintains full market exposure. The role of futures and of physical trading should be defined, too. Sensible use of both types of trading allows staff to achieve more than they could with either on its own.
In the past most pension funds rebalanced quarterly, but increasingly, thanks to better data flows, many are making monthly rebalancing the norm. A few have even moved to daily rebalancing. We recommend rebalancing as often as is practical. For most funds, that means monthly right now, but it soon might be practical for many funds to rebalance daily.
Rules for dealing with alternatives are needed, too. These are harder to trade, so managing the allocation to them requires a different approach.
Second, the policy should be designed with both practical and theoretical considerations in mind. For example, rebalancing to the edge of a range rather than the policy position has been shown to be superior in theory. But Russell policy generally calls for rebalancing to the original target position because that is more practical.
Third, personal views of the market should be kept out of the process. Any attempt to tweak rebalancing to justify a committee's view of where the markets are headed is inviting the dangers inherit in market timing without even ensuring clear monitoring of the impact of the decision.
Fourth, staff should be free to institute rebalancing without seeking approval. If ratification of each rebalancing action is required from a board or a committee, the process becomes unnecessarily cumbersome and might become confused with tactical asset allocation or other management issues.
Whereas it is normal that a change in the allocation of assets should be approved by an executive, a committee or even an entire board, rebalancing need not be subject to such approval. It should be impersonal and automatic so it is implemented as soon as the limits are reached.
Such questions as, "Is now a really good time to put money into equities?" or, "Do we really want to take money away from a manager who is outperforming?" should be raised, if they are raised at all, separately from the rebalancing discipline.
Rebalancing under a disciplined process will not improve returns every time. But over time, rebalancing will prove to be an effective and worthwhile tool and, as such, an essential part of any strategic asset allocation policy.
Bob Collie is a director of Frank Russell Securities Inc., Tacoma, Wash.