Systematic rebalancing: knowing when enough is enough

Regularly rebalancing a portfolio against the chosen investment strategy is no big deal - or so you might think. But there are pitfalls in practice, which prompted us to develop our Systematic Rebalancing approach.

Up to now, rebalancing has widely used Calendar rules or Bandwidths: While quarterly rebalancing, for example, shows the lowest risk compared to the investment strategy over time, bandwidth rebalancing can minimise transaction costs and achieve a higher return.

Bandwidths that are too narrow distort the picture

Investors often base their bandwidths on the volatilities of the corresponding asset classes. In this way, for example, the rather low-risk CHF bonds are given a narrower bandwidth than the more volatile Swiss equities.

The result is a distorted picture. If we analyse how often the respective ranges have been touched over time, it is noticeable that this is the case more frequently with CHF bonds. Compared to Swiss equities or other common asset classes, rebalancing is therefore triggered almost exclusively by CHF bonds.

As we show in the following example (see chart below), bonds have triggered rebalancings eleven times since 2006. However, Swiss equities, for example, have only done so once.

The reason for this lies in the interaction of the portfolio weights. If, for example, the value of equities falls, this has a direct impact on the weighting of CHF bonds in the portfolio. As a result, the volatility of the weighting of CHF bonds in the portfolio is higher than would be expected from the asset class itself. An excessively narrow band­width for CHF bonds therefore makes the bandwidths of other asset classes such as Swiss equities almost irrelevant.

Broad-based rebalancing

This calls for a new, broader-based approach: The problem with bandwidth rebalancing was the starting point for us at Zürcher Kantonalbank Asset Management to develop the systematic rebalancing approach.

Thanks to this approach, it is possible to reliably recognise turning points on the financial market from a Swiss multi-asset perspective. What's more, this approach has shown that stable excess returns are possible over time. The approach is therefore suitable for systematic implementation with actively managed category investments, as we demonstrate using the example of our sustainable product range.

For a broader support of the rebalancing signal, we take a balanced Swiss investment strategy with a broad coverage of asset classes as a basis in a first step. This includes CHF bonds, government and corporate bonds, Swiss equities, global and emerging equities, as well as Swiss real estate, gold and commodities.

More balanced overall

In a second step, we then calculate the ranges based on the volatility of the portfolio weights within this investment strategy. Taking into account the volatility of the weights as opposed to the volatility of the asset class has the great advantage that the interaction effects are taken into account. This gives CHF bonds, for example, wider bandwidths than is often the case with traditional bandwidth rebalancing. As a result, each asset class has the same chance of indicating a turning point and the entire rebalancing mechanism is more diversified.

The result of these two steps is our Systematic Rebalancing Signal. As it turns out, this is significantly more balanced overall than other approaches; all asset classes together have triggered an average of three rebalancings per year since 2006, without one asset class dominating the number of rebalancings. We have been implementing the signal in our systematic portfolios since September 2021. In the recent past, the signal indicated two important turning points (red circles) on the capital markets on 24 October 2023, triggered by emerging market equities, and on 20 March 2024, triggered by global equities.

The major advantage of the systematic rebalancing signal is that it can be applied to any portfolio and is therefore particularly suitable for active stock selection with additional tracking error from stock selection. In the live track record from June 2018 to May 2024, systematic rebalancing was able to increase the added value from our sustainable stock selection by an additional 0.8% (see chart below, light blue area) after transaction costs.

Recognising turning points

The implementation of the rebalancing strategy is an active decision that should be tailored to the investment objective. If you want to minimise the risk to the monthly rebalanced benchmark, calendar rebalancing is preferable. If the intention is to minimise transaction costs, then bandwidth rebalancing is the most common choice.

If, on the other hand, investors want to take advantage of the opportunity to hit turning points on the capital market, the systematic rebalancing signal is a good option. This also has the major advantage that it can be integrated without additional assumptions, especially in the case of active stock selection.