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MANAGING MULTI-ASSET STRATEGIESLarry Cao, CFAMarch 2016

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AUTHOR BIOGRAPHY

Larry Cao, CFADirector, Content, Asia PacificCFA Institute, Hong Kong Office

In his capacity as director of content for Asia Pacific at CFA Institute, Larry Cao con-ducts original research and develops educational products with a focus on the invest-ment industry.

Larry has 20 years of experience in the investment industry. Prior to joining CFA Institute, Larry worked at HSBC as senior manager for the Asia Pacific region. He started his career at the People’s Bank of China as a USD fixed-income portfolio man-ager. He also worked for US asset managers Munder Capital Management, managing US and international equity portfolios, and Morningstar, managing multi-asset invest-ment programs for a global financial institution clientele.

Larry has been interviewed by a wide range of business media, such as Bloomberg, CNN, the Financial Times, and the Wall Street Journal. He is also a frequent speaker at conferences, and his work has been published in academic and industry publications on the subjects of asset allocation, equities, exchange-traded funds, financial planning, fixed income, and retirement and saving behavior.

Larry graduated from the University of Notre Dame with a master’s of business administration degree. He was also a visiting scholar at the MIT Sloan School of Management.

Managing Multi-Asset Strategies identifies key challenges the investment management industry faces today in providing a sound solution to investors. The insights shared here by some of the most sophisticated institutional investors and the brightest minds in academia form the foundation for tackling these critical issues.

Paul Smith, CFAPresident and CEO

CFA Institute

CONTENTS

Multi-Asset Strategies: A Primer �� 1

Three Key Decisions in Formulating an Asset Allocation �� 4

An Advance in Portfolio Construction �� 7

Benchmarking for Success �� 10

Myron Scholes on the Challenges the Investment Management Industry Faces �� 13

To Rebalance or Not to Rebalance �� 16

© 2016 CFA Institute. All rights reserved. 1

MULTI-ASSET STRATEGIES: A PRIMERMulti-asset strategy is the latest name that the investment management industry has adopted for what has long been known as a balanced fund. Despite the fancy name, this subject affects all investors. Whether you are an institutional manager running billions of dollars or a retail investor looking after your own retirement portfolio, what we are about to discuss should be relevant to you in at least a few significant ways.

WHAT IS A MULTI-ASSET STRATEGY?Multi-asset strategy refers to the type of investment strategy that involves investing in various asset classes. Typically, this strategy uses an asset allocation program on top of the substrategies that invest in individual asset classes.

I’ve intentionally made this definition very flexible to encompass all the possible scenarios that are highlighted next.

WHAT ARE THE MAIN CATEGORIES OF MULTI-ASSET STRATEGIES?The old balanced funds were typically put together by combining a (core) stock fund and a (core) bond fund with some cash as a cushion. Over time, core stock and bond funds evolved into funds of multiple (sub)asset classes. A balanced fund made up of such stock and bond funds, each specializing in one segment of the market, should really be called an asset alloca-tion fund, although in most cases, such funds have simply kept the old balanced fund moniker.

In recent years, these products are increasingly sold under the multi-asset strategy name. Often, they adopt a tactical asset allocation program, which was rare prior to the global financial crisis.

There is a unique category of multi-asset strategy fund worth mentioning: strategies that intentionally cover only a limited segment of the entire universe. This “limited” segment can be anything—for example, alternatives, international, or growth equities.

The very popular target-date fund is also a type of multi-asset strategy. The difference between it and a typical multi-asset strategy fund is that target date funds have an asset allocation that varies with time—that is, the “target date” of withdrawal.

MAnAgIng MultI-Asset strAtegIes

2 © 2016 CFA Institute. All rights reserved.

WHAT ARE THE COMMON SUB–ASSET CLASSES INCLUDED IN MULTI-ASSET STRATEGIES?The four “main” asset classes are stocks, bonds, alternatives, and cash. Within each are multiple ways of slicing and dicing the classes.

Stock funds can be managed according to size (large, mid, small, and micro cap), style (growth and value), sector (consumer, financials, health care, industrials, technology, and so forth), and geography (Asia, Europe, Latin America, Japan, the BRICs [Brazil, Russia, India, and China], and so forth).

Bond funds can be managed according to duration (long, intermediate, and short term), credit (core, government, credit, high yield, and so forth), geography (global, United States, emerging markets, and so forth), and currency (US dollar, euro, and local currency).

Alternatives include various hedge strategies, infrastructure, private equity, and real estate, many of which are common in institutional multi-asset strategies. Retail programs generally cannot include many types of alternatives because of liquidity and regulatory constraints.

WHO USES THESE PRODUCTS, AND WHY?Asset owners, such as pension funds and insurance companies, are the main investors in multi-asset strategies. Individual investors often use them in their defined contribution plans, among other things.

Multi-asset strategies came into existence for two reasons. First, partly because of demand for product differentiation, the number of asset classes has exploded over recent decades, since the initial proliferation of the product category. Second, tactical asset allocation came into fashion after the global financial crisis and the name—multi-asset strategy—partly implies (accurately or inaccurately) more flexibility in the asset allocation component in these strategies.

WHO PRODUCES THESE PRODUCTS?They are generally offered by asset management firms. Some asset owners—for example, insurance companies and various types of pension funds—are both producers and users because they manage the assets in-house. Many asset owners hire consulting firms to manage multi-asset strategy products for them. The consultants generally develop and implement asset allocation programs and then select appropriate asset managers to implement them.

MultI-Asset strAtegIes


WHAT ARE THE SKILLS REQUIRED TO MAKE A MULTI-ASSET STRATEGY PRODUCT SUCCESSFUL?Multi-asset strategies are the decathlons of the investment industry. They require practi-cally every investment skill, from securities selection at the individual asset class level to asset allocation at the overall level. Among all the multi-asset strategy products I have come across, the vast majority are managed by multiple teams because it is rare to find all the required skills in one place, especially in today’s world, where investment talent has become highly specialized.

Managing a multi-asset strategy portfolio is very complicated. In the next three articles, I’ll share insights from some of the largest and most sophisticated investment managers on each of the crucial aspects:

1. Formulating an asset allocation strategy

2. Constructing the portfolio

3. Measuring performance



THREE KEY DECISIONS IN FORMULATING AN ASSET ALLOCATIONManaging a multi-asset strategy portfolio is very complicated. There are three important stages in the process: asset allocation strategy, portfolio construction, and performance evaluation. I’ll share some practitioners’ insights about each of these stages in separate posts. In this installment, I’ll focus on the formulation of an asset allocation strategy.

So, what are the most important considerations in this stage? At an AsianInvestor con-ference in Beijing last year, I asked a panel of experts from some of the world’s largest institutional investors—including South Korea’s sovereign wealth fund Korea Investment Corporation (KIC), the Second Swedish National Pension Fund (AP2), and Russell Investments—for their opinions. They shared three key decisions they all had to make in formulating an asset allocation strategy.

1. THE FIRST QUESTION IS, WHAT PIECES SHOULD GO IN THE PUZZLE? IN OTHER WORDS, WHAT ASSET CLASSES SHOULD YOU INCLUDE?

KIC started with a mostly global equity and fixed-income portfolio in 2005. Since 2008, its mandate gradually expanded to include alternative investments, such as hedge funds, infrastructure, private equities, and real estate, as former CIO Dong-ik Lee explained.

Tomas Franzén, chief investment strategist at AP2, remarked that the fund started up over 10 years ago. Its policy portfolio now includes emerging market debt and equities as well as alternative investments (private equity, real estate, timber and agriculture, and so forth).

The textbook answer to this question is that everybody should have the same pieces, with size (total assets or total net worth) being the only difference. In reality, however, investors have different levels of risk tolerance and home-country bias. They tend to start from the low end of the risk spectrum and stick closer to home and then move toward a global port-folio. People generally begin with domestic stocks and bonds and then transition toward the international, first with developed markets and then with emerging markets. Many institutional investors have also gradually added alternatives exposures in recent decades.

three Key DeCIsIons In ForMulAtIng An Asset AlloCAtIon


2. HOW ACTIVE SHOULD THE PORTFOLIO BE?There is no single right answer to this question. Investors will have to look at their own circumstances.

Whether active management can add value is a perennial debate. As Franzén put it, “Pure alpha is divine. And it’s quite expensive as well.” As a result, AP2 has been increasingly relying on enhanced index strategies to get market exposures and some other well-established drivers of return, especially in more efficient markets.

But many have not given up the fight entirely. KIC initially adopted a quantitative approach with low tracking error but has more recently started trying to add extra return by hiring research staff and becoming “more creative,” in Lee’s words. AP2 also realizes the value of active managers in particular asset classes. For example, AP2 believes that participating in the Qualified Foreign Institutional Investor (QFII) program is strategi-cally better than investing in H-shares and that it needs good external managers based in Greater China. These managers enjoy more freedom to deviate from the benchmark.

Unless you have proven skills investing directly or identifying external managers who do, (enhanced) indexing seems to be the natural solution.

3. SHOULD YOU MANAGE THE MONEY YOURSELF OR USE EXTERNAL MANAGERS?

“When expanding outside of Sweden, we hired external managers, which turned out less successful than we hoped. We have since developed tilted indexes and took assets in-house using a quantitative process. The exception is alternatives; all [are] managed externally,” said AP2’s Franzén. Similarly, KIC outsources about a third of its publicly traded securities and all alternatives.

Scott Anderson, head of equity research for Japan at Russell Investments, discussed its manager search process. “We try to understand qualitatively. . . their approach on top of conducting quantitative analysis of performance data and see if they are consistent. In particular, we screen for poor performance and see whether that can be explained by the philosophy.” Anderson believes that it is important to distinguish between luck and skill. “Being contrarian and delivering solid performance is a good indication of skill,” Anderson added.

Unless you have proven skills investing directly, hiring external managers seems to be a natural solution. And unless you have tremendous skills in trading operations and/or



running extremely large sums of money, you should not be doing your own index invest-ing because the top vendors in the business would have a tremendous cost advantage.

Answering these three questions correctly should be sufficient to get started managing a multi-asset strategy portfolio, be it an institutional fund or your personal retirement money. For more advanced discussions, stay tuned for the next two installments in this series.

An ADvAnCe In PortFolIo ConstruCtIon


AN ADVANCE IN PORTFOLIO CONSTRUCTIONWhat’s the secret sauce for making a multi-asset strategy successful? In December 2014, I asked this question of the speakers on my panel at the 6th Annual Southeast Asia Institutional Investment Forum in Singapore, and their answers all shared one thing in common: risk factor allocation.

These experts, hailing from some of the largest and most sophisticated institutional inves-tors in the region, also explained what their answers mean in terms of implementation.

RISK FACTOR ALLOCATION IS THE NEW FREE LUNCH.There is a saying in the investment business that “diversification is the only free lunch.” In that sense, it is rather accurate to state that, in the context of multi-asset strategies, risk factor allocation has become the latest and most effective approach to diversification. It’s the new free lunch.

In the days of balanced funds, most multi-asset portfolios invested in no more than a handful of asset classes because the fundamental rationale for having balanced funds is that stocks and bonds tend to have low or negative correlation over time.

In recent years, however, the number of asset classes in some large institutional portfolios has ballooned because of investor demand for differentiated and more sophisticated products. This trend has created a problem that is fundamentally against the principle of allocation: Many of these more granular “asset classes” are highly correlated with each other (!), so they bring minimum diversification benefits.

Chiew Kit Tham, managing director at GIC, told attendees at the forum that they have pared the number of asset classes in their program from 39 to 6 for this reason. GIC is a sovereign wealth fund set up by the Singapore government that manages hundreds of billions of the country’s foreign reserves. Instead of focusing on asset classes, GIC now focuses on a set of factors that it wants to be exposed to: equity risk with a bias toward emerging market growth equities, real estate, and private equity. It considers these to be the main drivers of its portfolio risk and return. Secondary drivers include such factors as momentum, size, value, credit, and carry.



Richard Brandweiner, CFA, CIO of First State Super, added that it has also shifted atten-tion away from asset classes. “Benchmarks for asset classes are quite arbitrary and are increasingly less relevant. We focus on what systemic exposures we try to capture with a certain asset class and target a portfolio with the desired mix of exposures,” said Brandweiner.

In a similar vein, Nachcha Protpakorn, deputy secretary general of Thailand’s US$20 billion Government Pension Fund (GPF), discussed its focus on long-term macro-economic drivers. Protpakorn believes the practice allows the GPF to take advantage of shorter-term opportunities without wandering too far from the long-term policy portfolio.

PROPER PORTFOLIO CONSTRUCTION IS CRITICAL IN REAPING THE BENEFITS OF RISK FACTOR ALLOCATION.The shift from asset classes to factors requires changes in the portfolio construction process.

For example, target allocations to specific asset classes become an afterthought. Brandweiner’s advice is to “avoid silos in thinking. Think of portfolio construction from a factor perspective, such as duration, credit, and currency. There is no bucket for a particular private equity or infrastructure fund, but think of their contribution as a group.”

Tham gave a similar example: To add high yield to a portfolio, an investor will need to reduce exposures to the equity and credit factors. Similarly, there will be no target alloca-tion to active and passive components of the portfolio.

These components are switchable in terms of factor exposures. Once appropriate funds are identified based on their risk–return trade-offs and so forth, allocations can be set in line with their factor exposures. Tham highlighted a case where the GIC would sell the “policy portfolio” to make room for new active funds.

Constraints defined in terms of asset classes will also need to be adapted, which makes sense given the previous two points. Although it sounds simple, it can often be the sticking point for funds with old guidelines that are set in terms of percentage of assets allocated to certain asset classes. So, be forewarned before you set out on this route.

All the speakers also highlighted the importance of understanding the economic rationale beyond running regressions on the few factors.

An ADvAnCe In PortFolIo ConstruCtIon


Risk factor allocation is one of the most important advances in portfolio construction techniques in recent decades. Institutional investors are catching on to the trend, but as I have demonstrated, the devil is in the details. In the next installment of this series on multi-asset strategies, “Benchmarking for Success,” I will share practitioner insights on how to set proper benchmarks.



BENCHMARKING FOR SUCCESSAlthough portfolio evaluation is the last step in the portfolio management process, it is by no means the least important. On the contrary, proper performance measurement, attribution, and appraisal can enhance the probability of success for the entire investment process. And improper evaluation, by contrast, can directly create some of the often-criticized issues in the investment industry. (For example, Nobel laureate Myron Scholes believes benchmark and tracking error can derail an investment process. I discussed what this meant with him in detail last week in Tokyo. Stay tuned for my write-up.)

In this fourth installment in the multi-asset strategies series, I discuss three important issues in portfolio evaluation and some institutional investor best practices.

1. HOW SHOULD WE DEAL WITH THE CONFLICT BETWEEN LONG-TERM INVESTMENT GOALS AND SHORT-TERM EVALUATION CYCLES?

Many investment managers follow investment processes that are inherently long term. For example, value strategies often take a full market cycle to bear fruit. If investors hold such managers to a quarterly evaluation cycle, conflicts often arise. Understandably, returns from such managers may end up in the bottom quartile in a quarter. Investors expecting otherwise will be disappointed. Worse, if the managers are forced to modify their process and deliver more consistent returns, they might be become disoriented. Smart investors have come up with different approaches to deal with this potential conflict.

According to Chiew Kit Tham, managing director at GIC, his firm measures its own performance over a 20-year horizon. He does not think the 65/35 equity/bond reference portfolio is appropriate for use as a short-term return yardstick; he believes it is more of a risk measure. He admits that external active managers have a much tighter leash, although private market managers are allowed more time to demonstrate their competence.

The success of the Thai Government Pension Fund (GPF) is judged by its performance relative to the consumer price index (CPI) over 10 years, says Nachcha Protpakorn, deputy secretary general of the GPF. Each year, the GPF also measures the portfolio’s performance against a global benchmark, which is reset each year opportunistically.

BenChMArKIng For suCCess


Measuring a multi-asset strategy’s long-term performance over inflation and short-term volatility relative to a simple equity-plus-fixed-income reference portfolio seems to help motivate managers to resolve the conflict between long-term goals and short-term evaluation cycles.

2. SHOULD PERFORMANCE EVALUATION BE QUANTITATIVE OR QUALITATIVE?

Various formulas come to mind when people talk about performance evaluation. The standard attribution formula is an integral part of the CFA® Program curriculum. GIC also uses regression analysis over various periods to measure return drivers—such as equity, emerging markets, and credit—in its portfolio. The team will then adjust portfolio exposures accordingly where necessary.

Richard Brandweiner, CFA, CIO of First State Super, prefers using the expert panel approach. His team focuses on the economic rationale and systematic exposures (i.e., factors) in its analysis. The team looks at each manager and debates what the key con-tributing factors are to the portfolio’s performance. Brandweiner limits the discussion to three exposures in each case so as not to overengineer the outcome. For the overall portfolio, Brandweiner crosschecks the return–risk exposure and the probability of achieving such exposure.

The key to performance evaluation is understanding the return drivers. There is no inherent conflict between the qualitative and the quantitative approach. In fact, I believe they are complementary. The quantitative approach can make the assessment more objective, while the qualitative approach might help illuminate the big picture and serve as a sanity check. A good quantitative model requires good intuition while good qualitative analysis can always benefit from the validation that a quantitative assessment of the same portfolio provides.

3. SHOULD PERFORMANCE FOR ACTIVE AND PASSIVE PORTFOLIOS BE MEASURED DIFFERENTLY?

Tomas Franzén, chief investment strategist at Second Swedish National Pension Fund (AP2), thinks so. AP2 has developed tilted indexes for portfolios that it manages in-house using an active quantitative process. It reserves the market-weighted indexes for use in evaluating the passive funds.



Using a tilted index is a natural evolution as our understanding of return drivers improves over time. A value manager will increasingly be asked to outperform the value index and not just the broad market as the investors are educated on the impact of value and other factors on portfolio performance.

An important caveat is that we need to not lose sight of the long-term goal (total return) of investing when drilling down to drivers of active returns. Total returns are apparently more relevant for asset owners and average investors, but understanding active return drivers is of critical importance in manager selection. Only a holistic review provides the full picture.

In summary, portfolio evaluation can be much more than just producing a scorecard. There are various approaches investors can take in the process to enhance portfolio performance.

Myron sCholes on the ChAllenges the InvestMent MAnAgeMent InDustry FACes


MYRON SCHOLES ON THE CHALLENGES THE INVESTMENT MANAGEMENT INDUSTRY FACES“You cannot spend relative performance,” I recall a colleague saying when I was starting out as an equity analyst at a mutual fund many moons ago. Of course, he was talking about how funds should be run. Should the focus be on achieving investment goals or beating the benchmark?

Recently, in Tokyo, I picked up the conversation again, this time with Nobel laureate Myron Scholes. Here’s what he had to say.

AN INVESTMENT MODEL BASED ON RELATIVE PERFORMANCE ACHIEVES THE WRONG RESULTS.The main message of Scholes’s 2014 research paper,1 co-authored with Peter Blaustein and Ashwin Alankar, is that the tracking error constraint we put on investment managers—coupled with their need to keep cash around for unexpected withdrawals—contributes to the underperformance of active managers. The authors’ analysis shows that (institutional) active managers as a whole would actually have beaten the benchmark otherwise.

This result makes intuitive sense. In “Benchmarking for Success,” I argue that there is often a conflict between investor demands that managers focus on the long term and that they not stroll too far from the benchmark during any given period of time—for example, a month or a quarter. So, when a good manager is catching on to something in a big way, it unfortunately coincides with big tracking errors, and we will pull them back with tracking error constraints.

DYNAMIC STRATEGIES CAN HELP INVESTORS ACHIEVE THEIR LONG-TERM GOALS.Scholes also shared with me the main message of a talk he went on to give before a full house at a CFA Society Japan event: The investment management industry should focus

1Ashwin Alankar, Peter Blaustein, and Myron S. Scholes, “The Cost of Constraints: Risk Management, Agency Theory and Asset Prices,” Working Paper No. 3086, Stanford Graduation School of Business (July 2014).



on the long term. “We have got a model for cross-section diversification,” he explained. “We have to balance that with time-series diversification because, when time diversifica-tion fails, cross-section diversification fails too.” (For those not quite fluent in the language of statistics, cross-section and time-series diversification roughly translate into static and dynamic asset allocation, respectively.)

“The greatest reward comes from time diversification,” Scholes observed. And I agree. For example, the best move most investors could have made in this lifetime is probably getting out of equities in 2008.

“There is a cost to [pursuing purely] static asset allocation,” Scholes said. “Is the risk of passive index strategies constant?” Instead of reflecting investor risk preferences in terms of a static asset allocation—which has fluctuating risk levels over time—Scholes thinks it makes sense to tie it directly to a target risk level. “Then the industry has to be proactive in estimating risk,” he commented.

“Many managers do not want to worry about risk,” Scholes continued, “so they leave the problem for the asset allocators, like the pension funds, to solve. ‘I only have to pick the winners. If the risk of my benchmark is changing, it’s not my problem.’ If the world gives you the same risk at each period, then it’s fine. But [laughter]. . .”

THE INVESTMENT MANAGEMENT INDUSTRY COULD BE FACING PROFOUND CHANGES.To the extent that one agrees with Scholes’s arguments, the industry is facing at least two major changes.

In a way, we’re now looking at a different piece of the puzzle, which places a different kind of demand on investment managers. We may need different skills to achieve the desired outcome. Managers think about alpha, and asset allocation people think about beta but in the sense of static asset allocation. We’ll need more people thinking about dynamic asset allocation, which is quite a change in both the mindset and skill set required.

Another important change that will have to take place is investor education. “You’ll need a whole new way of interacting with investors, ” Scholes said.

A helpful example is the Morningstar Style Box. It has been a great investor education tool that has made complex investment concepts accessible to retail investors. And yet, the benchmark-tracking error process embedded in the style box methodology makes

Myron sCholes on the ChAllenges the InvestMent MAnAgeMent InDustry FACes


the investment management process difficult. Many active managers believe they do not fit neatly in a box and hence are not properly evaluated.

“We have to design new measures,” Scholes said. “If you do not have an objective-based measure, you’ll need a different measurement. I don’t think there is a good measure yet for judging long-term performance. I would say, if you have a five-year track record, how do you evaluate a five-year performance? Because you have one five-year period. You’ll need a lot of five-year histories to do it.”



TO REBALANCE OR NOT TO REBALANCERebalancing is a topic that most professional money managers are familiar with and yet it is unclear to many whether it is a practice that actually adds value. I recently spoke with Jason Hsu, co-founder and vice chairman of Research Affiliates, on the subject while he was visiting in Hong Kong.

Based on our conversation, it seems like there is ample room for improvement. For example, are the people who have the most to gain from rebalancing actively engaged in the practice? Equally important, are those who are actively rebalancing actually benefiting from the exercise? These are questions to which all professional money managers should have crystal-clear answers formulated in their minds.

Enterprising Investor: Rebalancing is a somewhat mundane topic, but it is extremely relevant for practitioners. You have done research on the subject, and you are also an investor. Do you think investors should rebalance?

Jason Hsu: Statistically, there is documented intermediate-horizon mean reversion in equity returns and long-term mean reversion in asset class returns. A naive but effective way to benefit from mean reversion is to make sure that you regularly rebalance against past price movements. A lot of people call this “contrarian trading.” The magnitude of this rebalancing benefit is directly related to the magnitude of mean reversion. Where there might be potential disagreement about the benefit of rebalancing, it is due in part to language and definition. Some people define the benefit of rebalancing more narrowly.

So, there are two levels of rebalancing. One is at the asset class level for multi-asset strategies: You rebalance an asset class to its target weight. The other one is within each individual asset class: You rebalance each holding to its target weight. Which is generally more beneficial?

In terms of the benefit from rebalancing, it is larger when applied within an asset class.

Two features work in your favor when applying contrarian rebalancing within asset classes: (1) shorter mean-reversion horizon and (2) a larger cross section. Mean rever-sion is a very noisy signal; thus, you really need a lot of securities to make the effect work reliably. When you aggregate the effect across hundreds of securities within an

to reBAlAnCe or not to reBAlAnCe


asset class, the law of large numbers kicks in to wash out the noise and accentuate the mean-reversion effect.

When applying contrarian rebalancing across asset classes, if you don’t have many dis-tinct asset classes, the benefit would be more lumpy. Additionally, since the asset class mean-reversion horizon is a bit longer, you might have to wait a bit for the effect to really kick in and work for you.

I think the number of securities plays an important role, correct? Quant models may do a terrific job at picking stocks—for example, a model’s top five picks perform better than the top 10, the top 50 perform better than the top 100, and so forth. But if you look at individual buy and sell transactions, it’s harder to show that they actually add value. This is also why investors often question whether rebalancing adds value.

That’s a point oftentimes lost to more casual investors, in part because they are used to more traditional concentrated stock-picking managers, who supposedly have deep insights on every stock. But when it’s more quantitative in nature, the manager’s edge for each stock is actually relatively small. Most quant strategies attempt to exploit return patterns related to some assumed behavioral biases. However, these statistical patterns apply only on average; you are never quite sure how it will work for a particular stock at a particular point in time. This is why quant portfolios need a large number of securities. Rebalancing is a simple quant strategy aimed at taking advantage of price mean reversion; as such, it needs a large cross section of securities, or, as Richard C. Grinold and Ronald N. Kahn2 call it, breadth.

The classic argument of rebalancing to, say, a 60/40 portfolio, is more troublesome. You only have two asset classes, so you don’t have the law of large numbers on your side. The asset class mean reversion also takes place over a much longer horizon. We are talking about a minimum of five years. So, at that level, if you try to measure the rebalancing benefit, I’m not surprised that most wouldn’t find satisfying evidence. This is also related to the empirical observation that the Shiller CAPE [cyclically adjusted price/earnings] ratio, which is a popular quantitative signal for implementing contrarian rebalancing, has worked better for rebalancing among a number of equity indexes than for timing rebalancing from stocks to bonds.

The case for rebalancing, especially in the multi-asset context, is often made with the assumption that you have complete foresight. Obviously, these return (and risk) forecasts are often very far off.2Richard C. Grinold and Ronald N. Kahn, “Breadth, Skill, and Time,” Journal of Portfolio Management, vol. 38, no. 1 (Fall 2011): 18–28.



I think the average user grossly overestimates the benefit of estimating the optimal port-folio weight. What [these users] don’t realize is that the dispersion of expected returns for stocks and asset classes is very small. So, we frankly couldn’t tell whether a 5% weight to Apple is more optimal than a 1% weight with any degree of confidence. This enormous uncertainty suggests that the notion of “optimal portfolio weights” is not at all realistic and trading aggressively based on presumed optimal weights is probably not advisable.

So, you think investors can compensate for the fact that optimal weights are sensitive to return and risk facts by not taking these weights too seriously? How do investors rebalance in practice?

I think a lot of investors employ the following approach: Every year or two, you reformu-late your capital market assumptions to determine the right weights to rebalance to. Like we discussed before, the challenge is that if your expected returns are set incorrectly, you could be rebalancing to very bad target weights. It is almost worse than not rebalancing. It often involves using a portfolio optimizer to set the optimal weights. Case in point, if you thought the expected returns for equities and credits were going to be –10% for 2009 in response to the negative shocks from the global financial crisis, the portfolio optimizer would most certainly set 0% weights for these two asset classes, which wouldn’t have worked very well.

Let me share with you a really interesting finding on naive versus sophisticated asset allocation. Victor DeMiguel, Lorenzo Garlappi, and Raman Uppal3 ran a horse race between naive equal weighting and optimization-based investment strategies, where portfolio weights were optimized using a variety of models for expected returns. Note that the equally weighted portfolio essentially professes no understanding of expected returns and covariance for securities; it only captures mean reversion. Surprisingly noth-ing beats equal weighting. So, it really drives home the point that, oftentimes, people’s dissatisfaction with regularly rebalancing to target weights isn’t that rebalancing your portfolio is somehow a bad concept. The poor experience is largely driven by the fact that your desired target weights coming out of an optimizer were not very good to start with. In some ways, fear and greed (and perhaps hubris) can cause us to focus too much on shifting the portfolio weights (often counterproductively) and thus forgo or diminish the benefit of contrarian rebalancing to capture mean reversion.

If most people can’t do it right, then isn’t rebalancing less interesting?

There is another approach to rebalancing—what I like to call the “lazy approach.” It doesn’t really use advanced theory to forecast returns and then optimize. Essentially, 3Victor DeMiguel, Lorenzo Garlappi, and Raman Uppal, “Optimal versus Naive Diversification: How Inefficient Is the 1/N Portfolio Strategy?” Review of Financial Studies, vol. 22, no. 5 (May): 1915–1953.

to reBAlAnCe or not to reBAlAnCe


investors start with a policy portfolio that isn’t concentrated in a handful of securities or asset classes. If you then regularly rebalance back to this starting static weight, you should do alright over time in terms of capturing the mean-reversion effect. I think for the aver-age investor [who lacks] special forecasting skill or who is more prone to overconfidence in her return estimates, this lazy approach to rebalancing probably works best.

The lazy camp rules. Is there an optimal frequency for rebalancing?

You really don’t want to overfit the data and say, “Okay, for large-cap US stocks, I rebal-ance every 11 months because it gives the best looking backtest.” Determining the optimal rebalancing frequency is most likely a data-mining exercise that won’t produce useful out-of-sample performance. Heuristically, I think rebalancing once a year seems quite dependable; it helps you avoid a lot of the short-term momentum effect.

Sounds like a good rule of thumb. After taking into account all these challenges that investors face, what are some of the strategies that benefit the most from rebalancing?

I think it is useful to think of contrarian rebalancing as buying cheap after prices have fallen and then selling high after prices have rallied. In a way, it is a flavor of value invest-ing. For markets where value investing has historically worked well, contrarian rebalanc-ing also works well. For example, contrarian rebalancing works really well for Japanese stocks, small-cap stocks, and emerging market stocks, on average.

Larry CaoContent Director, Asia PacificCFA Institute

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[email protected]://blogs.cfainstitute.org/investor/author/larrycaotwitter: @larryCaohK

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