Rebalancing is a fundamental strategy for maintaining portfolio diversification, but comes with hidden costs that can have a significant impact on returns. A predictable rebalancing policy puts large pension funds on the forefront, bringing billions of dollars in annual losses.
Rebalance ensures fairness and consistent diversification of your fixed income portfolio. Without it, the traditional 60-40 portfolio would not remain at 60-40 for a long time. In bull markets, for example, equity will ultimately overwhelm your portfolio.
However, the rebalanced 60-40 portfolio is an aggressive strategy to buy losers and sell winners. Like me Previous research Such a rule-based rebalancing policy could potentially increase portfolio drawdowns.
According to my new working paper, portfolio rebalancing has a much bigger problem, but it also costs investors an estimated $16 billion a year.Unintended consequences of rebalancing.” Co-authored Alessandromelon At Ohio State University Michele Mazoreni At Capital Group.
The approximately $20 trillion pension fund and the Target Date Fund (TDF) are subject to a fixed target rebalancing policy. Although the US stock and bond markets are relatively efficient, the enormous size of these capital means that they readjust pressure even if the price impact is temporary.
Large transactions should not be expressed in advance, but most funds are transparent about rebalancing policies, so in many cases rebalancing transactions are public knowledge in advance. This exposes them to front running.
Rebalance between threshold and calendar
How does this work? There are two main methods of rebalancing: Thresholds and Calendar.
In the latter, they are usually rebalanced to a specific date at the end of a month or quarter, and in the former, they are remitted after the portfolio violates a certain threshold. For example, a 60-40 portfolio with a 5% threshold will recur at 55-45 if inventory is declining and 65-35 if it is rising.
Whatever the method, rebalance is predictable and anything predictable appeals to the front runner. They know that rebalance trade includes market-changing amounts and buy orders increase prices. Therefore, they anticipate rebalancing and make easy profits.
My analysis using Melone and Mazzoleni conservatively estimates that the rebalancing cost will be 8 basis points (BPS) per year, or about $16 billion. Therefore, if the rebalancing fund needs to buy the stock and the price is $100, Frontrunners will promote up to $100.08.
8 bps could attack some as nothing more than a rounding error given how much control the total capital pension and TDF control, but in reality, 8 bps could exceed the annual transaction cost.
Furthermore, our estimates may underestimate the true impact. In fact, our paper shows that if the stock is overweight in the portfolio, for example, 65-35, the funds sell stocks and buy bonds, with a 17 bps return down the next day.
Another way to put it is: The average pension fund or TDF investor loses $200 a year due to these rebalancing policies. That could amount to a month’s worth of contribution. On the 24-year horizon, it is worth up to two years.
Our results also show that this effect has been enhanced over time. This makes sense. Given the rapid growth of pensions and TDFs, those transactions are likely to affect prices.
Pension Manager: “We know this.”
We were naturally skeptical when we discovered that rebalancing costs could exceed the total transaction costs of a transaction. As a real-life check, in June 2024, we presented our results to a private roundtable of senior pension managers collectively representing approximately $2 trillion in assets. To our surprise, their response was, “We know about this.”
We delved deeper. If you know about this, why not change your policy to reduce this cost? They said they need to pass the investment committee and the bureaucratic obstacles are too sudden.
“It’s easier to send signals to Alpha Desk,” said one CIO, who acknowledged the procedural difficulties. It has been paused. “Does this mean you’re running through your own rebalancing and rebalancing other pension funds?” I asked. The answer was “Yes.”
Our paper explains the magnitude of this problem. We don’t propose any specific solutions, but we need to stop rebalancing at the end of the month and quarter. Pensions must be forecasted in rebalancing. Too much retirement benefits are left on the table and then skimmed by the front runners.
On May 13th, Alessandro and I will discuss the paper at a webinar hosted by the CFA Society United Kingdom. would you like to join When identifying costs hidden in traditional rebalancing strategies, we explore ways to minimize market impact while maintaining disciplined asset allocations, discuss innovative approaches, and protect your organization’s portfolio from frontline activities.
