Portfolio growth is more than just the weighted compound returns of its underlying stocks. There is also the additional return contribution from the diversification benefit a portfolio experiences through consistent rebalancing, based on the weights, volatilities and correlations of the stocks it holds. As we mentioned in a previous blog, we call this added return potential the excess growth rate.
But the degree to which investors successfully tap into it depends on their rebalancing approach. Their approach ultimately determines the potential rebalancing premium.
The figure below illustrates how a realized rebalancing premium may help add to long-term portfolio returns. This example shows the cumulative excess returns of an equal-weighted S&P 500 portfolio, rebalanced quarterly, compared to the traditional market-capitalization weighted version of the index, which follows a buy-and-hold construction that is not regularly rebalanced.
Investors should consider three inputs that can considerably affect the degree of rebalancing premium that may be potentially captured:
1) What are the individual stock weights the portfolio is rebalancing back to? We use an equal-weighted portfolio in our example as a simple way to illustrate the potential additive effects of the excess growth rate. Further optimizing a portfolio’s individual holdings, in terms of weighting size, how those weightings are determined and even number of securities, can have a significant impact on the return contributions from both the weighted compound returns of the underlying stocks and also the potential size of the excess growth rate.
2) What are the relative stock volatilities and correlations across portfolio holdings? Stochastic Portfolio Theory demonstrates that the excess growth rate depends only on stock weights, volatilities and correlations. Higher volatility and lower correlations among stocks potentially offer a higher excess growth rate (though notably not necessarily a higher overall return). Excess growth rates have been trending lower in U.S. markets over the past several years, which is unsurprising given that broad cross-sectional stock volatility has likewise declined. This dynamic has historically been cyclical in nature. There have been other periods where the market’s excess growth rate has been similarly low and subsequently rebounded—often sharply and suddenly, taking many investors by surprise. Further, while the potential benefits of the excess growth rate are usually greatest during periods of higher relative volatility, they are still available to some degree in all periods.
3) What is the rebalancing frequency? Rebalancing frequency also plays a critical role in the size of the excess growth rate potentially captured. Its potential additive effects have tended to increase with frequency, as shown in the next chart, which again uses a simple example comparing the excess returns of equal-weighted S&P 500 portfolios rebalanced at various frequencies. This is because there is less volatility capture as rebalancing becomes less frequent. Of course, it is important to balance any potential rebalancing premium with managing trading costs efficiently, where the potential reward from rebalancing does not exceed the cost of the trades required to implement.
Systematic rebalancing can offer significant added return potential over time, though the magnitude can vary depending on a number of factors, some within investors’ control and some not.
See What a More Sophisticated Approach Looks Like
We’ve covered some of the theoretical underpinnings of how diversification and rebalancing can be an alpha source, even in a simple implementation. But what if you optimized it? Learn more.
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