By Michael Thomas
We call it "rebalatization." We've coined the word to describe a cost-effective strategy that combines rebalancing with cash equitization in a way that our analysis and our clients' experience suggest can significantly improve a fund's risk-and-return characteristics.
Indeed, we estimate the strategy last year improved total fund performance by an average of 43 basis points over what performance would have been had the strategy not been used. At the same time, tracking error relative to policy was reduced.
Granted, 2003 was a year in which the benefits of one leg of the strategy — rebalancing — were clearly demonstrated. Without rebalancing, a typical asset allocation of, say 60% equities and 40% bonds would have drifted to a 65% allocation to equities by the end of the year.
A closer look shows that by mid-March, such a fund would have been underweight equities by 2.5% just when equities, as measured by the Russell 3000, were beginning a 20% rally relative to bonds over the next three months. That underweighting, combined with the rally, would have translated into a 50 basis-point hit to performance for those who did not rebalance.
If history is a guide, asset allocation drift is a significant source of underperformance for the average pension fund. Attribution analysis of a universe of large funds over nine years shows the average impact of asset allocation mismatch to policy was a negative 13 basis points a year. This universe consists of funds that typically have rebalancing policies of three to five percentage-point bands around their target allocations.
Pension fund adviser Keith Ambachtsheer discovered a similar negative effect from asset allocation mismatch (negative 21 basis points) using a different set of funds over the last decade (Pensions & Investments, Jan. 26).
The studies show that even with rebalancing policies in place, the impact from asset allocation drift can be significant and can be negative over long time horizons. Losing 20 basis points a year from drift is a strong headwind to overcome when most funds would be happy with a total excess return of 50 to 100 basis points.
Rebalancing requires selling the overweight asset class while buying the underweight asset class. You can practice this principle without necessarily initiating additional trades and therefore without incurring additional costs.
Here are two ways you can do so:
c Use cash flows as an opportunity to rebalance. When cash enters the fund, the "rebalatization" strategy suggests you invest in the underweight asset class. Likewise, when a fund needs to raise cash, you should sell assets from the overweight asset class. As the fund is already forced to trade, the incremental cost of trading the correct asset class is essentially zero.
c Use the appropriate form of equitization. The correct use of cash equitization is key in the other leg of the strategy. Equitization using stock futures is a great solution — about half the time. The reason: If you are already overweight equities, you are only exacerbating the situation by overlaying your cash with equity futures. The mismatch is perpetuated and while you have solved one problem, you are creating another. The solution — if you are overweight equities — is to overlay any residual cash with fixed-income futures, not equity futures. Clearly if you are overweight fixed income you should use equity futures.