A passive buy-and-hold strategy is an alternative to a strategy of rebalancing to fixed weight. The capital allocation within the portfolio will drift as market prices change, but the investor remains passive. In contrast, the active rebalancing strategy will restore the target fixed weights.
The motivations behind a rebalancing strategy are straightforward. First, the drifting weights, implied by the buy-and-hold approach, might become extreme as assets diverge and few investors would remain passive indefinitely. The strategy of rebalancing to fixed weights puts this adjustment process on a regular schedule.
The so-called “rebalancing premium” is a second motivation for the fixed-weights strategy. The premium refers to the extra returns that the rebalancing process generates under certain circumstances. Consider how such profits might arise. Divergent asset performance will cause the weights to differ from the target allocation. To restore the desired allocation, the investor must buy some of the underperforming assets and sell some of the outperformers. Buying low and selling high has an intuitive appeal, and provided there is mean reversion in relative asset performance, rebalancing to fixed weights might generate positive returns.
On the other hand, when assets diverge strongly over time, fixed-weight rebalancing might cause losses relative to buy-and-hold as the rebalancing continues to increase the allocation to the underperforming asset.
The performance difference between fixed weights and drift weights shows the characteristic return profile (sometimes called negative convexity) of an investor who has sold both put and call options (although no actual options are sold of course). This profile shows positive, but limited, returns under small moves and large negative returns under large moves. The driver is the divergence in stock and bond returns because differences in return change the allocation.
Buying losers and selling winners is the essence of rebalancing to fixed weights. Market dynamics ultimately determine whether such a trading strategy is profitable. A trendless environment, especially one characterized by mean reversion, would clearly be friendly to this strategy. However, trending markets, e.g. where equities keep losing relative to bonds, pose a problem for rebalancing. A sustained trend means one buys an asset on the way down. Trending is a well-established property of markets over the last century and remains an important trading signal. One ignores trends at one's own peril.
Rebalancing is therefore no free lunch, but represents an implicit bet against diverging asset performance. The cost occurs when markets trend and rebalanced portfolios experience deeper drawdowns than buy-and-hold portfolios. For small values of stock-bond return divergence, fixed-weight rebalancing modestly outperforms buy-and-hold; for large divergences, the underperformance of the rebalancing strategy is marked. This extra risk is therefore a fundamental property of the dynamic behavior of the rebalanced strategy.