Rebalancing not so simple with diverse beta sources

Simple reblancing of portfolios back to strategic ranges after a market rise or fall is not as simple as you may think, according to a research note from brokers Morgan Stanley. The new investment required after a fall may be surprisingly large.

Morgan Stanley has long been an advocate of slow rebalancing by pension funds and in the latest research note the broker says that when a fund uses a slow rebalancing strategy, the portfolios with a high beta variance enjoy the greatest positive “convexity” in asset value.

What this means is that certain portfolios, such as those with a high dispersion of beta sources – with high beta variance – will lead to more desirable lower betas in falling markets and higher beta values in rising markets.

The researchers say that the movement of a fund’s beta from its intended value can involve a “second order convexity” effect depending on the distribution of beta components within the portfolio, giving an extra kick to the movement.

This affects the amount of rebalancing needed to bring the portfolio back to its target beta after a market move.

“Rebalancing liquidity is often underestimated,” they say. “For example, after a 30 per cent market decline, a 7 per cent equity purchase is needed to bring a standard 60:40 portfolio back to its initial 60 per cent equity exposure. With higher convexity, the required liquidity for rebalancing would be even greater.”

It is more difficult and complicated controlling tracking error and maintaining a prescribed beta target for funds with high beta variance, with a high dispersion of beta sources.

“On the other hand, a high beta variance leads to the more desirable beta values in falling markets and higher beta values in rising markets,” the researchers say.

The beta shift after a market move can be directionally asymmetrical and surprisingly large in magnitude. But the “second order convexity” effect can also come into play, depending on the specific distribution of beta components within the portfolio.