Index Rebalancing: Is It Important?

Don’t overstate the importance of smart beta index rebalancing or confuse it with asset allocation or risk

Editor, Europe
Reviewed by: Rachael Revesz
Edited by: Rachael Revesz

Time to clear up the confusion about rebalancing when it comes to indices.

Rebalancing means looking at the index, say, every month or every year, and checking it still accurately represents its underlying stocks’ fundamentals such as their earnings and dividends. Stocks are then bought or sold accordingly to generate the performance one would expect based on these fundamentals.

This is a completely different story to rebalancing, say, a multi asset fund.

Your fund may have a 40 percent allocation to bonds and a 60 percent allocation to equities and every six months the fund manager will sell and buy securities to make sure this allocation split remains the same and therefore the risk is consistent.

Risk is important – after all, as an advisor you have probably chosen the fund to match your client’s risk profile, and you want to make sure the manager doesn’t let the fund “drift” out of this risk grade, otherwise the regulator could come down on you like a ton of bricks.

Yes, yes – nod of the head – I understand the importance of rebalancing and the consistency of the fund’s risk profile.

But, be careful not to apply these theories to a different context – smart beta indices. It is not the same thing as rebalancing your asset allocation, nor does it have the same effect on returns.

Felix Goltz, head of applied research at EDHEC Risk Institute, the French think tank and business school, said investors tend to take this notion of asset allocation rebalancing and apply it to smart beta indices, which is a different story.

“Formal arguments about mean reversion and equity premium are applied to indices but this is in a different context as we’re not talking about [the split between] equities versus bonds, this is about allocating to different stocks in the same market,” he said.

And it is important to note that index rebalancing does not always work in your favour, especially if it is done on a less frequent basis, according to academic studies.

Rebalancing tends to sell the winning stocks, expecting them to go down in future, while snapping up the losers, expecting them to increase in value. But we are forgetting the momentum effect – when the winners keep on winning.

“We know there is a momentum effect; we know that following the winners generates value, so how can rebalancing effect always generate value?” asked Goltz. “That doesn’t go too well with empirical facts.”

Eric Shirbini, global product specialist at ERI Scientific Beta, said he does not understand “all this talk” of the importance of index rebalancing.

“What I’m saying is we don’t understand what this rebalancing effect is: we can’t quantify it, we’ve tried to measure it - it doesn’t exist,” he said.

Unless, of course, you specifically intend to capture the index rebalancing effect. In that case you would opt for a provider who targets high frequency rebalancing with high turnover in order to generate a premium.

“But for standard indices from large providers with annual or semi-annual review, you can’t expect they will benefit from rebalancing,” said Goltz.

Research from Blitz and van Vliet in 2010 shows that a fundamentally-weighted smart beta index rebalancing in March would outperform the market cap index by 10 percent, whereas if it rebalanced in September it would underperform. In this case, a March rebalancing would have benefitted from the rebound in financial stocks in 2009. It is a specific example, but it shows that timing is important.

“To capture this “index rebalancing effect”, it is very dependent on the date you choose and the frequency of the rebalance – investors shouldn’t expect they automatically capture that performance,” said Goltz.

However, Goltz said index providers are moving towards automatically rebalancing every quarter, which means avoiding having to rely on ad hoc timing decisions.

For example, when Research Affiliates (RAFI) partnered with FTSE in 2005 to launch a fundamentally weighted index series, they decided to rebalance the indices every year. But when RAFI launched another series with Russell in 2011, the indices were set to rebalance every quarter.

This systematic approach has the benefit of reliable and consistent back-tested data to measure performance and tracking error, rather than asking investors to rely on the indexer making tactical – and successful – decisions about the right time to rebalance.

The question then arises, how do you manage the potential increase in turnover if the index is rebalanced every quarter?

Index providers have various methods to cope with this. One example is partial rebalancing – only rebalancing 25 percent of the stocks every quarter. Another way is to only rebalance when the weights of a stock moves a significant amount.

Understandably, advisors have heard about the power of rebalancing their funds to keep within a pre-determined risk grade for their client. But the danger comes when advisors apply this theory to the smart beta world.

There are other, arguably more important, things to consider when picking an index provider – like diversification and turnover, rather than hope for guaranteed outperformance from the rebalancing effect.

Rachael Revesz joined in August 2013 as staff writer. Previously an investment reporter at Citywire, she has a background in writing content for retail financial advisors and has covered a wide range of subjects in finance. Revesz studied journalism at PMA Media, which has since merged with the Press Association. She also holds a B.A. in modern languages from Durham University, as well as CF1 and CF2 financial planning certificates from the CII.