Rebalancing is widely praised as a miracle cure: if you keep the equity component largely constant by regularly shifting your ETF portfolio, you can control the risk and increase the return, they say. A differentiated analysis shows, however, that a “return bonus” is unlikely and the promised risk management is a mess. There are lots of to talk and writing about rebalancing. The recommendation is that investors should regularly trim their portfolio of exchange-traded index funds (ETF) down to the initially selected weighting of the asset classes . In this way the level of risk can be controlled. At the same time, “the return opportunities through countercyclical action” improved, according to the JustETF website, which is aimed at do-it-yourself investors.
The risk increases as the equity component increases
The starting position: Investors who proceed in a well-considered and systematic manner determine their personal asset allocation before investing. This means the rough breakdown of the ETF portfolio between safe and risky asset classes such as government bonds and stock. The prices of euro government bonds fluctuate significantly less than those of stocks. How high the fluctuations in an ETF portfolio are in total depends largely on the proportion of risky investments. As expected, the higher the equity, the higher the volatility and the maximum loss in value. Once a portfolio mix has been selected, it does not remain constant over time because the prices of individual asset classes develop differently. The next graph shows how much the share of equities in an ETF portfolio that started with 60 percent equities (60-40 portfolio) fluctuated over time if regular rebalancing was not performed.
Investors cannot control the absolute risk with rebalancing
Rebalancing ensures lower fluctuations in the equity quota. These fluctuations can be controlled via fixed upper and lower limits or via the frequency of rebalancing over time. The shorter the time intervals, the closer the equity allocation to the originally selected weighting. The next graph shows the fluctuations in the equity allocation of a 60-40 portfolio that was reset to the starting weighting once a year.
Which rebalancing rule is the best?
Anyone who opts for regular rebalancing is faced with the question of how often the ETF portfolio should be reset to the starting weighting. We examined various time intervals without considering trading costs and taxes for the 60-40 portfolio outlined above. Over the entire study period, an annual rhythm was most advantageous, also in comparison to rule-based rebalancing. With the latter, the original portfolio weighting between safe and risky investments is always restored when defined thresholds are exceeded.
Rebalancing the risky side of an ETF portfolio
So far, our test portfolio consisting of an equity ETF and a bond ETF was only concerned with restoring the selected division between safe and risky investments. The risky side of a well diversified ETF portfolio does not just consist of an equity ETF, but also of various risky asset classes such as emerging market bonds, high-yield bonds and gold. In our ETF portfolio guide, we showed you how you can put together a risky ETF portfolio that is almost unbeatable. This portfolio consists of seven asset classes (developed market stocks, emerging market stocks, emerging market bonds, gold, food stocks, high-yield bonds, real estate stocks ) that are equally weighted.
Why rebalancing can hurt the portfolio
The concept of rebalancing is based on the assumption that the prices of individual asset classes fluctuate around a trend that is rising, to which they always return. Phases of rising prices are followed by phases of falling prices. Financial market researchers speak of a regression to the mean or reversion to the mean. Studies show, however, that this phenomenon is not stable and cannot be observed in all markets. Constantly rebalancing an asset class in such a phase can only bring disadvantages, as new money always flows into a long-term loser investment. For this reason, too, the supposed advantages of rebalancing are at least questionable.