by Nicholas Granger, et al, via SSRN
Nicolas M Granger, Man Group
Douglas Greenig, Independent
Campbell R. Harvey, Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER)
Sandy Rattray, AHL / Man Systematic Strategies
David Zou, Man Group plc - AHL Man Systematic Strategies
August 28, 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.
Copyright © Granger, Nicolas M and Greenig, Douglas and Harvey, Campbell R. and Rattray, Sandy and Zou, David, Rebalancing Risk (August 28, 2014). Available at SSRN: http://ssrn.com/abstract=2488552 or http://dx.doi.org/10.2139/ssrn.2488552
