Portfolio rebalancing and its unintended consequences
Most investors — such as pension, sovereign wealth and mutual funds — strive for a targeted blend of stocks and bonds. Fluctuations in financial markets, however, can disrupt this blend, forcing investment managers to periodically sell or buy assets to rebalance their portfolios.
Although rebalancing is a common ― and beneficial ― investment tactic, new research reveals that it costs investors billions of dollars every year. The paper, “The Unintended Consequences of Rebalancing,” studies how current rebalancing policies by large funds affect aggregate price dynamics.
“Many pensions and other large institutional investors state explicit objectives. As such, their rebalancing programs are well known and predictable,” said Alessandro Melone, assistant professor of finance at Fisher. “However, this predictability creates a problem ― it allows certain investors to preempt the trades of these large investment funds, a practice known as front-running.”
Melone co-authored the working paper with Campbell R. Harvey, professor of finance at Duke University and a research associate at the National Bureau of Economic Research, and Michele G. Mazzoleni of Capital Group.
As part of their research, they convened a confidential round table discussion with public pensions officials about front-running rebalancing.
“We asked why pension rebalancing policies were not altered to minimize the front-running,” Melone said. “The pensions pointed out the considerable difficulty of getting their investment committees to make changes in rebalancing policies.”
Some participants in that discussion even shared that the front-running rebalancing was part of their own investment strategy and was a source of risk-adjusted profit ― commonly referred to as “alpha.”
“One pension said, ‘It was easier to send the signal to our alpha desk,’” Melone said. “This implied that the pension actively participated in front-running rebalancing.”
The costs of current rebalancing policies are substantial: The researchers estimate these costs amount to approximately $16 billion per year, which averages out to nearly $200 for the average U.S. household.
“Two hundred dollars may not sound like a lot, but many times it’s more than the annual fees someone might pay on their pension or account.” Melone said. “Furthermore, as rebalancing pressures are expected to grow stronger in the future with the expansion of investments such as Target Date Funds and other balanced funds, these estimated costs could increase substantially.”
While their research is the first to document the existence of a cost associated with rebalancing strategies, the question of how these costs can be reduced requires further exploration.
“As rebalancing is a key tool for portfolio diversification and managing liquidity, designing better rebalancing policies that preserve the benefits of rebalancing while minimizing its costs seems like a priority for future researchers and investors,” he said.
