Investment Insights

Rebalancing through an overlay strategy during periods of volatility

By Jan Mowbray/Parametric

Periods of high volatility create opportunities for investors to add value through portfolio rebalancing, yet many institutional investors face challenges in implementing a portfolio-rebalancing strategy that provides for discipline and responsiveness during volatile markets. 

A lack of consolidated current portfolio values and onerous formal decision-making and approval processes—coupled with the decision of determining the right time to trade—often delay identifying and acting on rebalance triggers. Once approval is obtained, coordinating with many managers to buy and sell physical securities or funds can be time consuming and expensive. Responding in a timely and efficient manner to unanticipated market moves under this scenario can be very challenging. How to address this challenge? 

Potential solution

Rebalancing through an overlay introduces daily monitoring, real-time portfolio rebalancing, and the potential for reduced transaction costs—all while improving policy-benchmark tracking. Daily monitoring by the overlay manager allows for immediate identification of and response to portfolio imbalances. When rebalancing is necessary, the overlay manager brings asset classes back to the policy target by using long or short positions of exchange-traded futures, exchange-traded funds, and swaps rather than directing purchases and sales of the investor’s individual holdings. After portfolio imbalances exceed predetermined thresholds, the overlay manager buys policy-benchmark exposure to fill underweight classes and sells policy-benchmark exposure to reduce overweight classes, therefore bringing the entire portfolio back to policy in a disciplined, timely, and cost-effective manner. Using an overlay program to implement a disciplined rebalancing program reduces behavioral biases and forces the discipline of buying low and selling high.

Advantages

• Timely and efficient reallocation of portfolio exposure
• Minimization of exposure gaps during the rebalancing process
• Tracking-error reduction through policy-exposure management
• Potential reduction in transaction costs compared with more traditional rebalancing

Example

The United Kingdom’s vote to leave the European Union in June 2016 is a prime example of how short-term volatility can produce a rebalancing opportunity. This unexpected event, popularly known as Brexit, pushed equity prices sharply lower and caused bond prices to rise around the world. In
the two US trading days following the June 24 vote, the S&P 500 Index closed 5.3% lower (see figure 1). However, the drop in equity prices proved to be temporary, and in the following days and weeks the S&P 500 recovered all losses, rising further to establish new all-time highs. 

Click image to enlarge chart.

Given the short-term nature of the equity sell-off and subsequent recovery, rebalancing via traditional methods would have limited an investor’s ability to benefit from the temporary volatility created by Brexit. Institutional investors who use an overlay manager to rebalance their entire portfolio back to target allocations once pre-established trading bands are surpassed can capitalize on unexpected and often temporary volatility in the marketplace caused by events such as Brexit. 

Conclusion

Adopting a preapproved, disciplined rebalancing strategy through an overlay program allows investors to adjust exposure quickly and relatively cheaply in times of high volatility – without the need to move any physical assets in their portfolio. In addition, automatic rebalancing removes uncertainty and behavioral implications that can lead to inaction or the wrong action. Reacting to market volatility with a focus on controlling policy-based risk often produces meaningful amounts of incremental return. Declining markets may continue to decline, of course. However, rebalancing is a policy-based exercise that tends to add return over multiple market cycles. The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Parametric or TEXPERS, and are subject to revision over time. 

About the Author:

Jan Mowbray is responsible for designing, trading and managing overlay portfolios at Parametric.