Factors Affecting Rebalancing Policy

In rebalancing, securities within a portfolio are adjusted based on their relative weights. Disciplined rebalancing tends to reduce risk while incrementally adding to returns. Interpretations of this empirical finding include the following:

1. Rebalancing earns a diversification return, in that rebalancing earns a return from being short volatility.
2. Rebalancing earns a return to supplying liquidity to the market.

Factors that Influence Rebalancing Policies

Factors positively related to optimal corridor width include transaction costs, risk tolerance, and an asset class’s correlation with the rest of the portfolio. The higher the correlation, the wider the optimal corridor because further divergence from target weights is less likely when asset classes move in sync.

The volatility of the rest of the portfolio is inversely related to optimal corridor width. An asset class’s volatility involves a trade-off between transaction costs and risk control. The width of the optimal tolerance band increases with transaction costs for volatility-based rebalancing.  

Question

All else equal, an asset’s volatility with the rest of the portfolio would most likely be described as:

1. positively related to corridor width.
2. inversely related to corridor width.
3. a matter of investor preference only.

Solution

The correct answer is B:

The volatility of the rest of the portfolio is inversely related to optimal corridor width. An asset class’s volatility involves a trade-off between transaction costs and risk control.

In other words, as the portfolio’s volatility increases, tighter controls are needed to reign in the more powerful movements of a volatile portfolio.

A is incorrect. The asset’s volatility with the rest of the portfolio is not positively related to the corridor width. The corridor width in a portfolio context refers to the allowable deviation from the target asset allocation. If an asset’s value changes significantly (i.e., it becomes more volatile), it may exceed the corridor width, triggering a portfolio rebalancing. However, this relationship is not positive; instead, it’s more accurate to say that higher volatility may lead to more frequent rebalancing if the corridor widths are kept constant.

C is incorrect. While an investor’s risk tolerance (considered a “preference”) will influence how much volatility they are willing to accept, it’s not accurate to say that an asset’s volatility with the rest of the portfolio is solely a matter of investor preference. Volatility is an inherent characteristic of an asset and its relationship with other assets in the portfolio, and it cannot be changed merely by investor preference. It needs to be managed through diversification and other risk management strategies.

Asset Allocation: Learning Module 4: Principles of Asset Allocation; Los 4(o) Discuss factors affecting rebalancing policy