34 Pages Posted: 30 Aug 2014 Last revised: 4 Oct 2014
Date Written: October 3, 2014
While a routinely rebalanced portfolio such as a 60-40 equity-bond mix is commonly employed by many investors, most do not understand that the rebalancing strategy adds risk. Rebalancing is similar to starting with a buy and hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets. The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns. The expected return from rebalancing is compensation for this extra risk. We show how a higher-frequency momentum overlay can reduce the risks induced by rebalancing by improving the timing of the rebalance. This smart rebalancing, which incorporates a momentum overlay, shows relatively stable portfolio weights and reduced drawdowns.
Keywords: fixed weights, 60-40, drift weights, constant weights, rebalanced portfolio, rebalancing, negative skewness, negative skew, short straddle, negative gamma, momentum overlay, negative convexity
JEL Classification: G11, G13
Suggested Citation: Suggested Citation