Rebalancing revisited: putting risk back on the table

By adopting a contrarian approach to rebalancing which takes account of both assets and liabilities, pension funds could enhance long-term returns and reduce the volatility within their portfolios, new research reveals.
Rebalancing Revisited, a paper by Syd Bone, former chief executive of VFMC, and Andrew Goddard, an ex-Russell investment veteran, advocates super funds rebalance to a preset target, for example an investment return target of CPI +5 per cent per annum.

Presenting the paper to the 2009 Biennial Convention of the Institute of Actuaries of Australia, Bone said the optimal investment outcome is obtained when a preset, reasonably achievable target is established and then periodic rebalancing is carried out with reference to that target.

The target might be an investment return, or the ratio of assets versus liabilities.

“Rebalancing has traditionally been done between asset classes,” Bone said. “A lot of super funds are finding that difficult and allowing their strategic asset allocations to drift.”

Bone said target rebalancing was “contrarian in nature”, requiring funds to underweight risky assets such as equities during bull runs and overweight risky assets during bear markets.

“This approach would be calling now for funds to start putting risk back on the table,” he said. “This can be difficult for trustees.”

Bone and Goddard “backtested” their rebalancing model and compared the results with what would have been achieved had the assets been invested in a conventionally rebalanced portfolio with 60 per cent of the assets in Australian equities and 40 per cent in Australian bonds.

The liability was taken as known to be $100 at December 31, 2008, and liabilities at previous dates were determined from both an actuarial and accounting standpoint.

The paper showed that a super fund which followed the proposed contrarian investment strategy and rebalanced relative to the actuarial liability for the 10-year period to the end of 2008 would have earned 8.5 per cent per annum compound and incurred less volatility in its asset to liability ratio than a pension fund which adopted the traditional rebalancing method.

Assuming a portfolio invested in a 60/40 mix of Australian equities and bonds, the super fund that followed the traditional rebalancing approach would have returned 7.9 per cent over the same period.

According to Goddard, the contrarian approach also outperformed the traditional approach over 20 years (from December 31, 1988) and over 70 years (from December 31, 1938).

Bone and Goddard admit there are practical difficulties in maintaining a contrarian target rebalancing approach, which “flies in the face of normal human behaviour”, which is to increase risk when ahead and reduce risk when behind.

“For this reason, any real world application of this kind of contrarian approach is most likely to succeed if it is ‘automated’, following a pre-agreed set of rules which do not envisage external review or override,” the paper noted.

“It will also almost certainly be necessary to limit the extent to which the automatic implementation is permitted to diverge from the ‘base case’ strategic asset allocation.”