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Rebalancing and Factor Returns: Separating The Wheat From The Chaff

FTSE Russell

FTSE Russell
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Director, Research & Analysis

Despite growing adoption of factors and factor investing, we still come across articles and publications, which seem to miss the point of portfolio rebalancing, diversification and factor returns.

There are two misconceptions we wanted to address in this blog:

  1. Regular portfolio rebalancing is a way to generate stronger portfolio returns.
  2. Factor returns are driven, or indeed, are a result of the rebalancing.

On the first point, we looked at several well-known investment strategies: Equal Weight, Quality, Low Volatility, Value and Market Capitalisation. For each strategy, we created two portfolios. One was reconstituted according to the investment strategy, every year in September, making sure that the stocks remained in the portfolio for the whole year from September to September (so no deletions or additions during the year). We called it “Non-Rebalance” portfolio.

The second portfolio was created using the first portfolio, but we rebalanced it every month back to the weights in the preceding September (unlike the first portfolio, which was allowed to drift from September to September). We called the second portfolio “Rebalance”.

We then compared performance of the two portfolios for each factor with the results presented in Table 1.

difference in mean monthly geometric return between rebalanced and on-rebalanced portfolios

Although the considered factors are quite diverse, the results seem to be surprisingly similar ‒ the proportion of the years in which the Rebalance portfolio outperformed Non-Rebalance portfolio is around 50% for all factors. Moreover, it is also hard to draw a conclusion from the evidence that a regular rebalancing is producing a consistent outperformance compared to non-rebalanced portfolios.

To demonstrate the fallacy of the second point, we follow and extend the ideas of Booth-Fama and some other authors by splitting the return of a portfolio into two parts: the “Diversification return” and “Strategic return”.

The Strategic return is defined as the weighted geometric return of portfolio constituents at the start of the period. It needs to be noted that Strategic return is a purely mathematical construct and not a portfolio you can replicated in practice.

Diversification return is defined as the difference between the actual portfolio return and its Strategic return.

Similarly to the first point, we consider Rebalance and Non-Rebalance portfolios for the same factors. The Strategic returns are the same by definition, as the portfolios have the same stocks with the same initial weights every September. The Diversification returns are different, but very similar and scattered around Y=X line, as per Figure 1 (we use the Quality factor, as an example, but the other factors show a similar picture). As we can see in Table 1, roughly half of the dots are above and below the line.

diversification return comparison

What is even more telling is that the Diversification returns for different factors are also similar.

We looked at the difference in Strategic returns and Diversification returns of factors and Market Capitalisation. An illustration for the quality factor is presented in Chart 2.

quality rebalance vs market cap rebalance

As Chart 2 shows, in most years, the difference in Diversification returns is negligible and significantly smaller than the difference in Strategic returns.

This means that the Strategic return is primary responsible for the difference in performance of the factors. By definition, the Strategic return is the weighted return of constituent stocks and is the same for Rebalanced and Non-Rebalanced portfolios. The fact that portfolios are rebalanced has the lesser effect on relative performance than the stock weightings in the portfolio.

We go into more detail and provide further examples in our recent publication but it is apparent that the belief that rebalancing portfolios will drive performance is not supported by the data.

Originally Posted on September 8, 2021 – Rebalancing and Factor Returns: Separating The Wheat From The Chaff

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