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Improve returns and reduce risk by Opportunity rebalancing

On many algo I see here, especially ETF's ones , the rebalancing / reallocating are done on specific calendar dates (e.g. daily, weekly or monthly), my gut feeling was that such balancing cycles arent efficient as they happen mechanically ignoring market conditions.
I found an intresting research that supports the notion of not using calendar rebalancing but an opportunistic rebalancing - that is the approach of looking frequently and balance only when you need to,

The main research findings are :
• Rebalancing not by calendar dates but by tolerance bands can increase returns by 0.5%. The best is to have 20% tolerance band and look frequently each 1,5 or 10 days if the 20% band was exceeded. This will capture the buy low / sell high opportunities. Regarding how often to look if the bands were exceeded - If class of assets is commonly down by +/- 20% then looking back 5 days is best returns/risk.
• Bands rebalancing are better for long term as there are going to be more volatile periods (e.g. balancing lot in trend periods adds costs of commissions) • Rebalancing using the recommendation above (e.g. 20% tolerance band), the backtest shows that commission and tax costs for frequent balancing are insignificant - an average of additional 3 trades a year per class by applying this rebalancing strategy

Full research in: http://www.tdainstitutional.com/pdf/Opportunistic_Rebalancing_JFP2007_Daryanani.pdf

3 responses

Rebalancing when it's not needed can lead to higher transaction costs, which can certainly add up. Thanks for sharing the paper. Alan posted a similar approach to rebalancing his algo in this thread (see the comment): https://www.quantopian.com/posts/is-this-a-good-rebalance-algorithm-or-does-it-need-work

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In general, rebalancing belongs to investment timeframes although I agree that it should be based upon economic rather than calendar considerations. The biggest concern I would have for short time periods for rebalancing is the flash crash scenario when equities can move down quickly in a day due to an unique event (e.g., 9/11 attack; Greece meltdown). One value I see for examining relative values among an universe of assets or ETFs is to identify the best short term vehicles for trading. Thanks for sharing the paper.

one can and should separate algo from execution, this should be implemented as an option in the execution framework instead of within individual algos