Investment Insights

THE INVESTMENT RESEARCH JOURNAL from BLACKROCK

September 2010 | Volume 13 Issue 3

9.10

Efficient Portfolio Rebalancing in Normal and Stressed Markets

Lydia J. Chan and Sunder R. Ramkumar

EXECUTIVE EDITORS
Ronald N. Kahn
415 670 2266 phone 415 618 1514 facsimile ron.kahn@blackrock.com

AUTHORS
LYDIA CHAN, CFA Vice President
Lydia Chan is a member of the BlackRock Multi-Asset Client Solutions (BMACS) group, which is responsible for developing, assembling and managing investment solutions involving multiple strategies and asset classes. Within BMACS, she is part of the Client Strategy team where she is responsible for working with clients and prospects to solve their investment challenges through research and analysis, and designing custom solutions across multiple asset classes and strategies. Ms. Chans service with the firm dates back to 2007, including her years with Barclays Global Investors (BGI), which merged with BlackRock in 2009. At BGI, she was a member of the Client Advisory Group, responsible for analyzing and structuring optimal portfolios of managers and asset classes for clients. Prior to joining BGI, she was a bank supervision associate at the Monetary Authority of Singapore. Ms. Chan earned a BA degree in economics and computer science from Cornell University, and an MS degree in management science and engineering with a concentration in finance from Stanford University.

Russ Koesterich
415 670 2576 phone 415 618 1875 facsimile russ.koesterich@blackrock.com

EDITOR
Marcia Roitberg
850 893 8586 phone 415 618 1455 facsimile marcia.roitberg@blackrock.com

SUNDER RAMKUMAR, CFA Director

Sunder Ramkumar is a member of the BlackRock Multi-Asset Client Solutions (BMACS) group, which is responsible for developing, assembling and managing investment solutions involving multiple strategies and asset classes. Within BMACS, he is part of the Client Strategy team where he advises strategic clients on investment policy, liability-driven investing and manager structure, and designs optimal plan-level investment solutions for clients. Mr. Ramkumars service with the firm dates back to 2003, including his years with Barclays Global Investors (BGI), which merged with BlackRock in 2009. At BGI, he was a senior strategist in the Client Advisory Group advising on total portfolio investment strategy issues. He also conducted research for BGIs advanced active equity strategies, and advised on new product development for defined contribution plans. His research has been published in financial journals, including the Financial Analysts Journal and The Journal of Fixed Income. Mr. Ramkumar earned a BE degree in mechanical engineering from Mangalore University in India, and an MS degree in management science and engineering with a concentration in finance from Stanford University.

The authors gratefully acknowledge insights provided by their colleagues Duane Whitney, Fred Dopfel, John Pirone, Catherine LeGraw, Dan Ransenberg, Chris Campisano, Kevin Kneafsey, Alex Ulitsky, Marcia Roitberg and three anonymous reviewers.
BlackRock

Efficient Portfolio Rebalancing in Normal and Stressed Markets

TABLE OF CONTENTS
Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Fixed Band Rebalancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Current Rebalancing Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Tracking Error Rebalancing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Investment Insights September 2010

Executive Summary
The goal of strategic rebalancing is to limit unintended drift, or tracking error, from the strategic policy benchmark without incurring large transaction costs.
Most institutional investors use a fixed band rebalancing policy in which the weight of an asset class is allowed to drift within specified bands. Investors should select band sizes based on their tradeoffs between tracking error control and transaction costs, and trade assets that breach bands to the midpoint between band edge and target weight. Other specifications have little impact on rebalancing efficiency. Overall, in normal market environments, fixed band rebalancing is relatively inexpensive and can control tracking error effectively. This is not the case in dislocated markets. Higher asset class volatility in stressed markets implies that the portfolio is exposed to significantly more tracking error, even when it stays within its target bands. Similarly, greater illiquidity in stressed markets implies substantially higher transaction costs, as investors must trade even illiquid assets if these have breached target bands. Both factors reduce the effectiveness of fixed band rebalancing in stressed markets. Tracking error rebalancing is an alternate approach in which investors monitor tracking error (rather than asset class misweights) and ensure that it stays below a specified threshold using trades that minimize transaction costs. Instead of trading all assets that breach the target bands, investors use current estimates of volatilities and costs to determine the trades that result in the most risk reduction per unit cost. In stressed markets, this strategy can help avoid trades in illiquid assets by exploiting asset class relationships to reduce risk at significantly lower costs. Investors should build the flexibility into their policies to switch to tracking error rebalancing in stressed markets, as volatility and illiquidity rise. The efficiency gains of tracking error rebalancing are generally more modest in normal markets. However, investors seeking increased flexibility in determining opportunistic asset allocation trades or guidance in liquidity management may benefit significantly from incorporating tracking error rebalancing as a part of their ongoing approach to portfolio rebalancing.

BlackRock

Introduction
During the credit crisis, as equity markets crashed, many investors found themselves significantly underweight equities and overweight fixed income.
At the same time, illiquidityparticularly in the fixed income marketmade conventional rebalancing prohibitively expensive. This raised several questions. Can rebalancing policies be improved? What levers are most important? Should investors adapt their strategies in stressed markets? In this paper, we evaluate rebalancing strategies in normal and stressed markets to identify the most efficient approaches. Rebalancing is essential in ensuring compliance with the asset allocation policy. Market moves drive the portfolio away from the strategic policy weights; over time, the portfolio tends to drift toward riskier asset classes. As an example, if a plan invested in a mix of 70% US stocks and 30% US bonds in 1950, by the end of 2009, absent rebalancing, the portfolio would have drifted to 99% stocks and 1% bonds.1 The unrebalanced portfolio can have dramatically different characteristics than the policy portfolio, which is designed specifically to meet plan objectives and risk tolerance. In any year, misweights between the portfolio and policy can cause underperformance. Rebalancing should be designed to limit the probability of underperformance, measured by tracking error. While rebalancing controls tracking error, frequent rebalancing can also cause underperformance due to the transaction costs of buying and selling assets. Therefore, in designing their rebalancing policy, investors should balance competing objectives of limiting

tracking error and controlling transaction costs. The most efficient rebalancing policy will achieve the desired degree of tracking error control at the lowest possible cost. The same considerations apply even if the policy weights change over time. In this case, the problem separates out into two steps. First, define the new policy weights based on revised estimates of long-term expected return, risk, risk tolerance or other considerations.2 Second, determine the rebalancing strategy relative to the new policy weights based on tracking error and transaction cost tradeoffs. Some studies evaluate rebalancing strategies based on the historical excess returns they would have generated. See, for example, Arnott and Lovell (1993). This can yield misleading conclusions based on the study period. Rebalancing can generate excess returns over policy in mean-reverting environments when overweight (underweight) asset classes are sold (bought) before they subsequently underperform (outperform). However, it can cause equal underperformance in trending markets. The excess returns are conditional on tactical views regarding the future market environment. They depend on the timing of trades and should be excluded from the strategic rebalancing decision. In a similar manner, strategic asset class expected returns should also be excluded. These have already been incorporated in determining policy allocations and should not influence the decision to rebalance. Rebalancing is thus an exercise in risk control and cost control. We use this framework to examine best practices in setting rebalancing policy. We begin by evaluating typical rebalancing strategies in normal markets and then move on to examine what works in stressed markets, where rebalancing can be challenging.

1 We calculate portfolio weights using the S&P 500 Index and Ibbotson Intermediate Bond indexes. 2 Sharpe (2010) suggests that changes in asset class market values imply changes in consensus expected returns, which should be incorporated into the policy portfolio. He proposes that investors should adjust policy weights in proportion to market moves, effectively reducing (but not eliminating) the need to rebalance. This recommendation results in policy portfolios with varying risk levels, which may be inconsistent with individual investor preferences. Furthermore, Leibowitz and Bova (2010) point out that, in addition to changing consensus expected returns, market moves may be driven by a variety of other factors including changing aggregate risk aversion, changing real yields and changing volatility, and therefore can result in conflicting policy recommendations. Investment Insights September 2010 3

Fixed Band Rebalancing

Rebalancing Tradeoffs in Normal Market Conditions The typical institutional investor uses fixed band rebalancing (see Current Rebalancing Practices on page 5). Investors specify fixed bands around the policy; when bands are breached, investors simply trade back to within bands. This is consistent with research that finds that fixed band rebalancing is more efficient than a periodic approach where all asset classes are rebalanced back to target (irrespective of misweights) at fixed calendar intervals (e.g., monthly or quarterly). See, for example, Leland (2000) and Donohue and Yip (2003). While most plans use fixed band rebalancing policies, there are four main levers to consider in designing these policies: 1. Average size of rebalancing bands: How wide should the rebalancing bands be?

2. Band size variation: How should the size of rebalancing bands vary for different asset classes? 3. Rebalancing destination: How far back to policy should investors trade assets that breach bands? 4. Asset class grouping: Should rebalancing bands be set around broad or narrow definitions of asset classes? We discuss each lever in turn and calculate how different choices affect rebalancing efficiency. In each case, we consider a typical policy and calculate the performance of alternate rebalancing rules using Monte Carlo simulations of weekly returns, based on asset class characteristics in normal markets (Exhibit 1).3 In each simulation, we assume that the portfolio begins on policy and is monitored monthly relative to static policy weights. We report the average tracking error and transaction costs of alternate rebalancing policies over a 10-year time horizon across 1,000 different simulation runs.4

Exhibit 1: Asset Allocation Policy and Normal Market Assumptions

Asset Class US Equity Non-US Equity Fixed Income TIPS Private Equity Real Estate Policy (%) 45 20 20 5 5 5 Expected Return (%) 7.75 7.75 4.50 3.50 9.00 6.75 Expected Risk (%) 16.00 17.50 5.00 5.50 18.00 15.50 T-Costs (%) 0.30 0.50 0.40 0.30 N/A 0.30

Correlations US Equity Non-US Equity Fixed Income TIPS Private Equity Real Estate
Source: BlackRock

US Equity 1.00 0.75 0.15 0.20 0.80 0.65

Non-US Equity

Fixed Income

TIPS

Private Equity

Real Estate

1.00 0.10 0.10 0.70 0.45 1.00 0.70 0.45 0.20 1.00 0.20 0.35 1.00 0.60 1.00

3 Risks and correlations are consistent with long-run historical data. Expected returns are based on a risk premium approach. Transaction costs are estimates based on typical costs for trading active portfolios. Our broad results are robust; alternate specifications of these inputs yield comparable results. 4 For simplicity, we assume no inflows and outflows from the portfolio. This results in conservative estimates of transaction costs because inflows and outflows can be used to reduce asset class misweights without the need for offsetting trades. 4 BlackRock

Current Rebalancing Practices

What are the most common rebalancing strategies in practice today? We surveyed the largest US public defined benefit pension plans and found that, overall, rebalancing policies are very similar. All the plans in our survey used static fixed bands, typically defined around a set of five to nine asset classes. Most plans had variable sized bands, but the average band size clustered between 3% and 5%. Bands were also typically

specified for private equity, though one plan grouped private and public equity to determine rebalancing trades. Only a few plans reported their rebalancing destination. However, a survey from SEI (2009) suggests that 73% of plans rebalance back to target weights when an asset class breaches its band. The histograms below summarize the differences in each rebalancing lever across the 25 largest plans.5

1. Average Rebalancing Band Size There was a wide range of band sizes across different asset classes and plans; however, the average band size across asset classes for each plan clustered around 35%.
10

Number of plans

23%

34%

45%

56%

>6%

2. Band Size Variation The majority of plans had variable sized bands across asset classes. Of these, a large proportion appeared to use bands that were larger for asset classes with larger weights. However, there was no other discernable pattern.
25 20 Number of plans 15 10 5 0

Equal

Variable

3. Asset Class Grouping Most plans dened bands around the typical asset classes (ve to nine asset classes). However, a few used narrow asset class denitions (10 or more asset classes), and one plan only rebalanced around two broad asset class groups. Several plans used a hybrid approach, combining bands around typical asset classes with bands around broad asset groups.
25 20 Number of plans 15 10 5 0

Narrow

Typical

Broad

5 Our sample includes the largest 25 public DB plans listed in the Pensions & Investments Survey (2009) that report rebalancing policies on their website. Investment Insights September 2010 5

1. Average Size of Rebalancing Bands: We consider three rebalancing policies with equal fixed bands of 1.0%, 3.0% and 5.0% for every asset class. In each case, an asset class that breaches its band is rebalanced all the way back to target weight.6 We allow the private equity allocation to drift, because it is illiquid and hard to trade. Exhibit 2 describes the rebalancing tradeoffs with tracking error on the x-axis and transaction costs on the y-axis. Transaction costs are depicted with a negative sign, since they lower portfolio returns. The goal is to be as far northwest as possible; that is, to generate the lowest tracking error at the least possible cost. Exhibit 2 illustrates that 3% bands imply an average tracking error of 0.32% and average annual transaction costs of 0.02%. Narrower bands imply lower tracking error (because they limit large drifts in portfolio weights) but also higher transaction costs (because they trigger more frequent rebalancing).

The right band size will vary from investor to investor, based on their individual preferences between tracking error and transaction costs (i.e., what level of tracking error is the investor willing to tolerate and how much are they willing to pay to control it). Exhibit 2 demonstrates that the slope of the transaction cost/tracking error line can increase sharply at lower levels of tracking error. Tightening bands from 5.0% to 3.0% reduces tracking error by the same amount as moving from 3.0% bands to 1.0% bands. In the latter case, however, the incremental costs are almost three times higher. This implies that it may not be cost effective to reduce tracking error to very low levels.7 The average band size is a key driver of rebalancing performance. Investors must understand the implications of alternate band sizes and select bands consistent with their tracking error and transaction cost preferences.

Exhibit 2: Impact of Average Rebalancing Band Size on Rebalancing Efciency

Average Annual Tracking Error (%) Average Annual Transaction Costs (%)
0.00 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80

5% Bands
0.02

3% Bands

0.04

1% Bands
0.06

0.08

Source: BlackRock

6 We use a simple heuristic to determine offsetting trades in other asset classes and select trades that reduce asset class misweights in proportion to the size of the misweights. 7 For plans with active management, the rebalancing tracking error tolerance can be selected relative to the degree of manager selection risk in the portfolio (i.e., the tracking error of the portfolio relative to policy due to active manager bets). The overall tracking error relative to policy is a combination of these two uncorrelated risks. While very high levels of rebalancing tracking error would cause incidental policy misfit returns to dominate the alpha from manager bets, modest levels of rebalancing tracking error do not increase overall tracking error significantly. As a simple heuristic, plans with active management might set their rebalancing tracking error between one quarter and one half of the manager selection risk. Since rebalancing tracking error and manager selection risk are uncorrelated, this would increase overall tracking error by 3% and 12%, respectively. 6 BlackRock

2. Band Size Variation: The band size variation specifies how band sizes should differ depending on the asset class. There are typically three types of band designs: a) Equal bands (as in the previous section): Ignore differences in asset class characteristics and assign the same band to every asset class. b) Proportional bands: Assign proportionately larger bands to asset classes that have higher policy weights. All else equal, asset classes with greater weights are likely to deviate from policy more than those with lower weights. Proportional bands are designed to limit the amount of trading required, by having wider bands for these assets. c) Risk- and cost-adjusted bands: Assign variable bands with an eye to controlling transaction costs and tracking error. This typically involves wider bands for asset classes that are more expensive to trade and narrow bands for more volatile assets. For example, Masters (2003) proposes bands for asset classes that are proportional to their rebalancing transaction costs and inversely proportional to tracking error squared.8

Exhibit 3 compares the characteristics of equal bands (1%, 3% and 5% equal bands) with proportional bands (5%, 15% and 25% of policy weight) and risk- and cost-adjusted bands proposed by Masters (using risk tolerances of 1.0%, 2.5% and 4.0%). The graph demonstrates that there is little discernable difference in rebalancing efficiency between the different rebalancing band designs. Risk- and cost-adjusted bands are appealing in principle but difficult to design, because the tracking error and transaction cost implications of different bands are difficult to predict. The tracking error caused by an asset class misweight depends on the positions of all the other assets. A 1% overweight to fixed income with a corresponding underweight to TIPS might imply a low tracking error, but a 1% overweight to fixed income with a corresponding underweight to equity would imply a much larger tracking error. Similarly, the transaction costs of trading an asset class also depend on the offsetting trades required. For example, the cost of rebalancing a largecap equity overweight is relatively low but may also require offsetting purchase of expensive assets.

Exhibit 3: Impact of Band Size Variation on Rebalancing Efciency

Average Annual Tracking Error (%) Average Annual Transaction Costs (%)
0.00 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80

0.02

0.04

0.06

Equal Proportional Risk- and Cost-Adjusted

0.08

Source: BlackRock

8 Masters calculates the tracking error for an asset class assuming that the asset class overweight (or underweight) is offset by underweights (overweights) in all other assets in proportion to policy weights. Similarly, expected transaction costs are calculated assuming that when an asset class breaches its band, it is traded back to target, and offsetting trades are made in all the other asset classes in proportion to their policy weights. Investment Insights September 2010 7

Since the efficiency gains from variable bands are modest, some investors may prefer the simplicity of equal bands. These require few assumptions and control tracking error effectively at a low cost in normal markets. 3. Rebalancing Destination: The destination defines how far back to policy to trade asset classes that have triggered a rebalance. There are three typical choices: a) Trade the asset class all the way back to target (as in the previous sections), b) Trade only to the edge of the band, or c) Trade back to the midpoint between target and edge. Exhibit 4 contrasts the characteristics of fixed band rebalancing policies with the three different rebalancing destinations. In each case, we consider three rebalancing policies with equal rebalancing bands for every asset class of 1.0%, 3.0% and 5.0%. The line representing trading back to target is below the other two rebalancing alternatives, indicating that this approach is least efficient. Investors can achieve the same tracking error at a lower cost by trading to the edge (or to the midpoint) of a band that is slightly tighter. For example, Exhibit 4 illustrates that an investor can design a set of bands between 3%

and 5%, rebalanced to edge (or to the midpoint), that have the same tracking error as 5.0% bands rebalanced to target, but with lower transaction costs. These findings are consistent with results in Brown, Ozik and Scholz (2007) and Leland (2000). The inefficiency of trading back to target stems from two sources. First, trading back to target locks in larger up-front transaction costs than trading to the edge, where there is a possibility that the misweights will be naturally corrected by market moves. Second, the additional degree of tracking error control from being back at target can be modest, as there are other asset classes that are still misweighted. Trading to the edge is efficient but typically requires frequent (small) trades, because an asset that is traded to the edge of the band might require a rebalance in the very next period. In our simulations for 3.0% bands, trading to edge requires a trade every 4 months as opposed to every 15 months for trading to target. Instead, plans may choose to rebalance to the midpoint between target and band. As Exhibit 4 indicates, this efficiency is similar to trading to the edge but with much less frequent trading (every 12 months for 3.0% bands).

Exhibit 4: Impact of Rebalancing Destination on Rebalancing Efciency

Average Annual Tracking Error (%) Average Annual Transaction Costs (%)
0.00 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80

0.02

0.04

0.06

Trade to Target Trade to Edge Trade to Midpoint

0.08

Source: BlackRock

BlackRock

4. Asset Class Grouping: Grouping determines the definition of an asset class for the purpose of setting bands. We consider two alternatives: a) No grouping: Uses asset class definitions consistent with the asset allocation policy (US equity, international equity, US fixed income, etc.). b) Broad grouping: Sets rebalancing bands around broad asset categories (e.g., around the total equity portfolio and the total fixed income portfolio rather than on the individual asset classes within these groupings). Narrow asset class definitions provide better tracking error control in environments where correlated asset classes behave differently. For example, in an inflationary environment, nominal bonds and inflation-linked bonds typically have significantly lower correlations than in normal environments; simply focusing on the aggregate bond allocation may provide a misleading measure of tracking error. However, narrow asset class definitions may also create situations in which a plan must sell an overweight asset class (e.g., small-cap growth) despite the fact that it has an underweight in another highly correlated asset class (e.g., small-cap value) that essentially offsets the tracking error. The net result, illustrated in Exhibit 5, is that alternate asset class groupings do not change rebalancing efficiency materially. Most investors

may simply default to asset class definitions consistent with their policy, while investors with tactical views on return opportunities of different asset classes may prefer broader groupings that provide more flexibility in determining trades. A small portion of plans group only private equity with public equity and retain other asset class definitions. Since private equity is illiquid, this strategy effectively uses public equity as a proxy trade, and is an alternative to leaving the private equity allocation unrebalanced. Investors should consider grouping private and public equity; this generally results in a modest reduction in tracking error, compared with allowing private equity to drift, with similar transaction costs (Exhibit 5). Rebalancing Efficiency in Stressed Market Conditions Our analysis so farand practically every study of rebalancing policyhas focused on normal market conditions. Fixed band rebalancing is effective in controlling tracking error and transaction costs in normal markets. However, as we saw during the credit crisis of 20082009, market conditions can change dramatically over time. In 2008, we saw volatility spike. The VIX index of equity volatility hit an all-time high, and real estate volatility was three times as high as its long-term average. Liquidity was also a significant concern, particularly in segments of the

Exhibit 5: Impact of Asset Class Grouping on Rebalancing Efciency

Average Annual Tracking Error (%) Average Annual Transaction Costs (%)
0.00 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80

0.02

0.04

0.06

Typical Grouping Broad Grouping Grouping Private Equity with Public Equity
0.08

Source: BlackRock

Investment Insights September 2010

fixed income market, and drove up the costs of trading. The cost of trading securitized and credit bonds moved to 250 basis points or more, while in typical markets the same bonds traded for just 20 bps. Both volatility and illiquidity reduce the effectiveness of fixed band rebalancing. Higher volatility exposes the portfolio to more tracking error, even when it stays within target bands. Illiquidity implies substantially higher transaction costs, since the investor must trade even illiquid assets when they breach target bands. Exhibit 6 contrasts the performance of fixed band rebalancing (with equal bands, rebalancing to midpoint between band and edge, no grouping) in stressed markets against normal markets using Monte Carlo simulations. The stressed market simulations use assumptions consistent with data from 2008, with higher asset class volatility and correlations and transaction costs that are substantially higher for fixed income. The graph illustrates how the tracking error from fixed band rebalancing can effectively double in stressed markets with substantially higher transaction costs.

Exhibit 7 provides a historical perspective on volatility and liquidity. Since historical transaction costs are difficult to obtain, we use credit spreads to proxy periods of illiquidity. The graph demonstrates that markets go through periodic dislocations. Three stress periods stand out: 1987, 20012003 and 20082009, each of which is associated with a market crash. Market crashes cause the biggest portfolio dislocations and generate the greatest need to rebalance. However, they are also followed by an environment of higher volatility and illiquidity in which fixed band rebalancing is least effective. This suggests that fixed band rebalancing fails plan investors precisely when rebalancing is most critical. Investors need a more responsive rebalancing policy that adapts to market conditions.

Tracking Error Rebalancing

Tracking error rebalancing is a market-aware alternative to rebalancing that explicitly focuses on reducing tracking error at the lowest possible cost. Instead of using bands as a proxy, investors specify a tracking error tolerance directly.9 As the portfolio drifts from policy, investors

Exhibit 6: Fixed Band Rebalancing and Tracking Error Rebalancing in Alternate Markets
Average Annual Tracking Error (%) Average Annual Transaction Costs (%)
0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 Fixed Band Normal 0.18 Fixed Band Stressed 0.20 Tracking Error Stressed Tracking Error Normal 0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00

Source: BlackRock

9 The tracking error tolerance is generally a constant, but investors may retain the flexibility to change it over time based on tactical views (e.g., reducing tracking error if there is conviction that misweights will lead to underperformance) and/or cost considerations (e.g., allowing greater tracking error if the cost of reducing tracking error is found to be prohibitive). 10 BlackRock

calculate the expected tracking error based on current estimates of asset class volatility and correlation.10 If the expected tracking error is greater than the specified tracking error tolerance, investors use a mean-variance optimization to determine the lowest-cost trades11 required to bring tracking error within threshold.12 Tracking error rebalancing can help investors identify key sources of tracking error. Rather than trading all assets that breach threshold bands, investors can use tracking error rebalancing to optimize trades, focusing on trades that may reduce risk the most per unit cost. In dislocated markets, it helps investors avoid trades in illiquid asset classes and instead exploit asset class relationships to reduce risk at a fraction of the cost of fixed band rebalancing. Exhibit 6 highlights the differences between fixed band rebalancing and tracking error rebalancing in both stressed and normal market environments, based on Monte Carlo simulations. To facilitate a comparison, we examine tracking error rebalancing policies with triggers designed to

yield the same tracking error as corresponding fixed band rebalancing policies. In typical market environments, when transaction costs are similar across asset classes, fixed band rebalancing (solid dark blue line) works well. It controls tracking error and transaction costs, and it is only marginally less efficient than tracking error rebalancing (dotted dark blue line). In contrast, tracking error rebalancing creates significant efficiency gains in stressed markets (dotted light blue line), achieving the same tracking error as fixed band rebalancing (solid light blue line) at about half the cost. Tracking error rebalancing produces efficiency gains relative to fixed band rebalancing by exploiting differences in relative asset class volatilities and transaction costs to reduce risk inexpensively. While precise volatility forecasts can be difficult to make, relative asset class volatilities are generally stable. Equities have consistently been more volatile than bonds, and emerging market equities have consistently been more volatile than developed market

Exhibit 7: Historical Market Volatility and Liquidity

110 100 90 80 70 5.0 7.0

Credit Spreads Equity Risk

6.0

60 50 40 30 20 10 0
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

4.0

3.0

2.0

1.0

0.0

Source: Bloomberg. Equity risk based on annualized daily volatility of S&P 500 (12/85 12/89) and VIX (1/90 4/09); Credit spreads based on Barclays Capital U.S. Credit Bond Index.

10 There is a large body of work on forecasting volatilities and correlations based on historical data. See Litterman and Winkelmann (1998) for a summary. In our work, we find that an exponentially weighted covariance matrix using monthly data with a 12-month half-life provides a reasonable balance of responsiveness without causing excessive trading. 11 See Grinold and Kahn (2000) for an overview of transaction cost models. In practice, estimates of asset class transaction costs are available from brokers and portfolio managers. 12 The ideal optimization would also consider expected transaction costs and expected tracking error for future periods. Practically, however, this makes the optimization computationally intensive and difficult to solve. See Kritzman, Myrgren and Page (2009). In the absence of time-varying forecasts of returns, covariances and transaction costs, the single-period optimization used here is an effective proxy. We simulated performance of the single-period optimization using the same assumptions of Kritzman et al. and found that single- and multi-period optimizations produce similar tracking error and transaction cost characteristics. Investment Insights September 2010 11

Credit Spreads (%)

Equity Risk (%)

equities. Similarly, relative asset class transaction costs can be estimated fairly accurately based on recent transactions and market quotes. Therefore, despite the fact that precise volatility estimates are hard to develop, and correlations can be unstable over time, tracking error rebalancing produces robust results. In a historical backtest (described in the Appendix on page 16), we find that tracking error rebalancing would have produced efficiency gains relative to fixed band rebalancing in each of the three stress periods that occurred from 1985 through 2009. Not only is tracking error rebalancing more efficient, it is relatively easy to implement and produces intuitive results. To see how tracking error rebalancing works, we consider the following simple case study based on market conditions at the beginning of 2009.

Tracking Error Rebalancing Case Study Consider an investor with a typical 70/30 policy allocation. If the portfolio began on policy weights at the start of 2008, market moves through the year would have driven the portfolio to be underweight equities by 10% and overweight fixed income by 9% by year-end, as illustrated in Exhibit 8. Based on updated estimates of asset class volatilities and correlations, we can calculate the tracking error relative to the policy associated with these misweights. For example, volatilities and correlations derived using an exponentially weighted time series of asset class data with a 12-month half-life (Exhibit 9) imply an annualized tracking error of 2.3%. Without a view on relative asset class performance, there is a 1-in-10 chance that the portfolio will underperform the policy by 2.9% or more in the following year. This is significant and highlights the need for rebalancing.

Exhibit 8: Example Portfolio Mists and Sources of Mist Risk

Example Portfolio Mists (%) Sources of Tracking Error Fixed Income 4.3% 0.2% 0.3% 1.9%

US Equity Non-US Equity Fixed Income TIPS Private Equity Real Estate
10

5.8%

TIPS Private Equity Real Estate 9.3%

4.2%

US Equity 54.3% 1.8% Non-US Equity 39.1%

0.4%

0.7%
5

10

Expected Tracking Error

Source: BlackRock

2.3%

12

BlackRock

While considering options to reduce risk, it is instructive to examine the sources of tracking error in the portfolio. This is illustrated in Exhibit 8. Equities are the largest source of tracking error, due to their high observed volatility. Despite the fact that fixed income has a misweight that is two times as large as US equities, the contribution to tracking error is less than 5.0%. This foreshadows why a fixed band rebalancing approach, which focuses only on misweights and ignores the tracking error implications, is likely to be inefficient. We consider three rebalancing options, illustrated in Exhibit 10: 1. Fixed band rebalancing to +/3% bands, 2. Tracking error rebalancing trading physicals, and 3. Tracking error rebalancing using derivatives.

An investor using a conventional fixed band rebalancing policy (option 1) must sell 6.3% of fixed income to get back within the 3% band and buy the corresponding amount of equities (5.1% US and 1.2% non-US). This reduces tracking error by over 50%, from 2.3% to 1.0%. However, based on asset class transaction cost estimates consistent with market conditions in 20082009 (Exhibit 9), these trades entail an estimated one-time cost of 17.8 bps. This cost, which is about 10 times higher than typical rebalancing costs in normal markets, is chiefly driven by the high cost of trading credit and securitized bonds during the illiquid fixed income markets of 2009. Alternatively, the investor can use tracking error rebalancing by determining the cheapest trades required to reduce tracking error to the desired level (option 2), represented by the dark blue efficient frontier in Exhibit 10.

Exhibit 9: Input Assumptions for Case Study

Asset Class US Equity Non-US Equity Fixed Income TIPS Private Equity Real Estate S&P 500 Futures 10-year Treasury Futures Policy (%) 45 20 20 5 5 5 Expected Risk (%) 19.75 24.00 5.25 9.75 24.00 37.00 19.00 10.25 T-Costs (%) 0.30 0.50 2.50 0.30 N/A 0.30 0.10 0.10

Correlations US Equity Non-US Equity Fixed Income TIPS Private Equity Real Estate S&P 500 Futures 10-year Treasury Futures
Source: BlackRock

US Equity 1.00 0.95 0.15 0.45 0.95 0.80 0.99 0.00

Non-US Equity

Fixed Income

TIPS

Private Equity

Real Estate

S&P 500 Futures

10-year Treasury Futures

1.00 0.30 0.55 0.85 0.70 0.90 0.00 1.00 0.80 0.15 0.20 0.15 0.75 1.00 0.45 0.50 0.45 0.50 1.00 0.90 0.95 0.00 1.00 0.80 0.25 1.00 0.00 1.00

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The frontier is calculated using a mean variance optimization similar to that used in asset allocation (the tradeoffs are between transaction costs and tracking error instead of expected return and risk). The optimization suggests that if the investor buys 1.8% US equity, 4.3% non-US equity and 0.7% REITs, and also sells 6.8% TIPS, the portfolio would achieve the same tracking error reduction as option 1 at a fraction of the cost (4.9 bps compared with 17.8 bps). While the fixed income overweight remains

outside the 3% bands, these transactions reduce the largest source of tracking error by reducing the equity underweight, and avoid trades in illiquid fixed income by funding the equity purchase with TIPS. We find that the decision to trade TIPS is independent of the correlation between TIPS and nominal bonds. TIPS are sold because they are liquid and can fund the equity purchase easily, not because they represent a proxy for nominal bonds.

Exhibit 10: Rebalancing Options

Expected Annual Tracking Error (%)
Expected Costs (% one time)

0.00

0.00

0.40

0.80

1.20

1.60

2.00

2.40

2.80

Current Portfolio Option 3

0.05

Option 2

Option 1: Fixed Band Rebalancing to +/ 3%

Buy 5.1% US equity, 1.2% non-US equity Sell 6.3% xed income

0.10

Option 2: Tracking Error Rebalancing Trading Physicals

Buy 1.8% US equity, 4.3% non-US equity, 0.7% REITs Sell 6.8% TIPS
0.15

Option 3: Tracking Error Rebalancing Using Derivatives

Long 7.8% S&P 500 futures Short 4.7% 10-yr Treasury futures Sell 3.1% TIPS for cash collateral

0.20

Option 1

Option 1: Fixed Band Rebalancing to +/3%

Option 2: Tracking Error Rebalancing Trading Physicals

4.0%

Option 3: Tracking Error Rebalancing Using Derivatives 2.1%

US Equity Non-US Equity Fixed Income TIPS Private Equity Real Estate
10

0.7%

3.0%

0.1% 3.0% 1.8%

5.0% 0.4%

4.2%

9.3%
1.3% 0.4%

4.5%

0.4%

0.7% 5

0.0% 0 5 10
10 5

0.7%

10

10

10

Mists Relative to Policy (%)

Mists Relative to Policy (%)

Mists Relative to Policy (%)

Option 1

Option 2

Option 3

Costs Expected Tracking Error (%)

17.8 bps 1.0

4.9 bps 1.0

4.7 bps 1.0

Source: BlackRock

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Our analysis thus far has focused on strategic rebalancing. The tracking error rebalancing approach also allows investors to incorporate tactical views in determining rebalancing trades. Rather than optimizing tracking error against transaction costs, investors with high-conviction tactical views would instead optimize tracking error against expected alpha from misweights net of transaction costs. For example, if an investor in 2009 was convinced that TIPS would outperform in the months following the crisis, the optimization would suggest selling nominal Treasuries or other liquid assets in the portfolio. Portfolios with limited liquidity can benefit from the use of derivatives for rebalancing (option 3). Derivatives are capital efficient and can help investors rebalance their asset class exposures without buying and selling large amounts of physical assets. The derivatives market is also typically liquid and provides tremendous flexibility in controlling asset class misweights. The light blue efficient frontier in Exhibit 10 illustrates how trading just two simple futuresthe S&P 500 and 10-year Treasurycan reduce the largest sources of tracking error. By taking a 7.8% long position in S&P 500 futures and 4.7% short position in 10-year Treasury futures, while selling 3.1% of TIPS for margin requirements, the investor can achieve the same tracking error reduction as option 1 at a much lower cost. Tracking Error Rebalancing: Sometimes or All the Time? Our analysis demonstrates that investors can benefit from switching to tracking error rebalancing in stressed market conditions. Should investors also use it as the core rebalancing philosophy? While tracking error rebalancing produces a more modest improvement in normal market conditions, this approach can have three important advantages. First, the tracking error rebalancing framework can provide guidance for liquidity

management. When investors are looking for liquidity and considering trade options, tracking error and transaction costs should be the key decision factors. Second, it can help investors monitor the risk exposures of their portfolio and flag large sources of tracking error. Finally, it may provide investors with the flexibility to make opportunistic asset allocation trades without being constrained by fixed asset class bands. This flexibility may yield higher returns for skillful investors, without increasing portfolio tracking error. Tracking error rebalancing is based on a core philosophy of optimizing risks, returns and costs. Since most investment problems incorporate these elements at some level, it can be a valuable addition to a plans asset allocation toolbox.

Conclusions
Most discussions on rebalancing tend to focus on rebalancing levers such as size of rebalancing bands and whether to trade all the way back to target or not. While there are modest differences across rebalancing levers, overall, typical rebalancing policies are effective and control tracking error inexpensively in most markets. In normal markets, what matters most is designing a rebalancing policy that is consistent with the investors ability to tolerate tracking error and then sticking with it. The choice of rebalancing policy becomes significant in stressed markets. Investors who use a tracking error rebalancing approach (or build in the flexibility to switch to tracking error rebalancing in stressed markets) can rebalance effectively despite higher volatility and illiquidity. This requires investors to change their mind-set to focus on risk rather than misweights, and to adopt a new approach for determining rebalancing trades. As we saw in 2009, a systematic process for analyzing rebalancing trades can go a long way toward improving plan performance.

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Appendix
We use a historical backtest13 to examine the sensitivity of tracking error rebalancing to forecast errors in asset class volatilities and correlations. Three stress periods are evaluated, defined by elevated volatilities and credit spreads: the market crash of 1987 (10/879/89), the dot-com crash (02/0112/03) and the credit crisis (01/0809/09). We compare the performance of tracking error rebalancing with a fixed band rebalancing policy that has 3.0% equal bands across all public asset classes. The policy weights are taken from Exhibit 1. In each case, we assume that the portfolio begins on policy at the beginning of the period. In the fixed band approach, we trigger a rebalance if any asset class breaches the 3.0% fixed band, and continue to rebalance the portfolio throughout the stress period as needed. In the tracking error approach, we monitor the portfolio tracking error based on an exponentially weighted covariance matrix that has a 12-month half-life using monthly data. To facilitate a comparison, we only begin the rebalancing in the same month that the fixed band policy first rebalances, and we calculate the lowestcost trades required to bring down the tracking error to

the same level as with fixed band rebalancing after its trades. In other words, the tracking error trigger is simply the tracking error of the fixed band rebalanced portfolio after its first trade. We continue to monitor the portfolio tracking error and calculate lowest-cost trades based on this tracking error trigger. Since historical transaction cost data are not readily available, we assume that the transaction costs in each of the stressed periods are equal and consistent with the costs we observed during the 2008 credit crisis (see Exhibit 9). The graph below tabulates the realized tracking error and total realized transaction costs in each stress period. It illustrates that tracking error rebalancing would have been more efficient than fixed band rebalancing in each of the periods, providing lower transaction costs at similar or lower realized tracking error levels. The magnitude of improvement was the highest during the 2008 credit crisis, when the dislocations were severe and prolonged. The improvement in efficiency was less during the 1987 market crash, when the market recovered soon after and conditions improved.

Realized Annualized Tracking Error (%) Total Realized T-Costs (%)

0.00 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40

Fixed Band Rebalancing 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 Stock Market Crash (19871989) Tracking Error Rebalancing

Dot-Com Crash (20012003)

Credit Crisis (2008 2009)

13 We used the historical returns of Russell 3000, MSCI World ex-US, Barclays Capital US Aggregate, Barclays Capital US TIPS, Russell 2000 and FTSE US NAREIT indexes to represent the US equity, non-US equity, fixed income, TIPS, private equity and real estate asset classes respectively. 16 BlackRock

References
Arnott, Robert D. and Robert D. Lovell. 1993. Rebalancing: Why? When? How Often? The Journal of Investing 2, no. 1 (Spring). Brown, David T., Gideon Ozik, and Daniel Scholz. 2007. Rebalancing Revisited: The Role of Derivatives. Financial Analysts Journal 63, no. 5 (September/October). Donohue, Christopher, and Kenneth Yip. 2003. Optimal Portfolio Rebalancing with Transaction Costs. The Journal of Portfolio Management 29, no. 4 (Summer). Grinold, Richard C., and Ronald N. Kahn. 2000. Active Portfolio Management. 2nd ed. New York: McGraw-Hill. Kritzman, Mark, Simon Myrgren and Sebastien Page. 2009. Optimal Rebalancing: A Scalable Solution. Journal of Investment Management 7, no. 1 (First Quarter).

Leibowitz, Martin, and Anthony Bova. 2010. Policy Portfolios and Rebalancing Behavior. Morgan Stanley Portfolio Strategy Note, March 3. New York: Morgan Stanley Research North America. Leland, Hayne E. 2000. Optimal Portfolio Implementation with Transactions Costs and Capital Gains Taxes. Unpublished manuscript, Haas School of Business, University of California, Berkeley. Litterman, Robert, and Kurt Winkelmann. 1998. Estimating Covariance Matrices. Goldman Sachs Risk Management Series, New York: Goldman, Sachs & Co. Masters, Seth. 2003. Rebalancing. The Journal of Portfolio Management 29, no. 3 (Spring). SEI Institutional Solutions. 2009. Rebalancing Reset: A New Approach in a New World of Institutional Investing. Sharpe, William F 2010. Adaptive Asset Allocation . Policies. Financial Analysts Journal 66, no. 3 (May/June).

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Investment Insights
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