Little Big Details

Little Big Details




by Corey Hoffstein, Newfound Research

This blog post is available as a PDF download here.

  • Limited attention drives us to focus on the big details of investment strategies.
  • Small details can have an outsized impact on performance, especially if they can compound upon one another.
  • To quote Aaron Brown, Head of Risk at AQR: “It takes a lot of compounding to turn a mistake into a disaster. There will never be any shortage of mistakes […].  So it’s the compounding you have to prevent, not the mistakes.”
  • We believe details like how frequently to rebalance and when to rebalance are too often overlooked and can have a dramatic impact on investor results.

In the world of asset management, attention goes to the big details.  Details like: “what are we investing in?”  Or, “what is the process?”  And without a doubt these are very important things.

Yet our limited time and attention often leaves us to gloss over the small details.  Our expectation is that the big things should have a big impact and the small things should have a small impact.

That is not always the case.

In this commentary, we are going to discuss two small things – the frequency of rebalancing and when rebalancing occurs – to show that small things, done wrong, can have an outsized impact on long-term results.

How Frequently Should We Rebalance?

The standard protocol for most systematic strategies is to rank the investment universe based upon some sort of signal or score, with the assumption that a stronger signal forecasts a higher future return.  At each rebalance, the portfolio tilts towards those securities with the strongest signals and away from those with the weakest (or even sells them short).

Assuming our signals correlate strongly with forecasted returns, to maximize our expected return we would want to rebalance as frequently as possible so that we are always holding the securities with the strongest signals.

Solely maximizing expected return, however, with no consideration of risk, may not be prudent.  Consider that the optimal choice to maximize expected return would be to continuously rebalance into the single security with the strongest signal, subjecting the portfolio to a tremendous amount of idiosyncratic risk.

Maximizing expected returns may not result in maximized realized returns, however, as the returns we expect and the returns we realize can be quite different.  In the case where our investment decisions can compound upon themselves, variance can play a dramatic role in returns.

Rather, investors will likely prefer to maximize expected return subject to some risk level or tracking error threshold.  This added wrinkle means that diversification will play an important role in how frequently we need to rebalance, particularly in the face of transaction costs, taxes, operational costs, and whipsaw costs (we’ll shorthand these as “turnover costs”).

To get an idea for this, let’s pretend for a moment that we are managing a value portfolio.  (For simplicity’s sake, we’re going to assume that stocks within our portfolio are held in an equal-weight fashion.)

In the face of turnover costs, how frequently we will want to rebalance our portfolio will depend upon a number of factors:

1. How large is our portfolio?

If there are N stocks in our portfolio, then the average stock will have to fall N/2 positions before it needs to be removed.  Furthermore, the larger N is, the smaller the change is to the portfolio when a security is removed.  Turnover costs for small changes may exceed the increase in marginal risk-adjusted return, and thus we would only want to rebalance at a frequency when there are enough changes to warrant the costs.

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