Rebalancing is a fundamental strategy for maintaining portfolio diversification, but it comes with a hidden cost that can significantly impact returns. Predictable rebalancing policies expose large pension funds to front-running, resulting in billions of dollars in annual losses.
Rebalancing ensures consistent diversification in equity and fixed-income portfolios. Without it, a traditional 60-40 portfolio wouldn’t stay 60-40 for long. In a bull market, for example, the equity would eventually overwhelm the portfolio.
But a rebalanced 60-40 portfolio is still an active strategy that buys losers and sells winners. As my previous research shows, such rule-based rebalancing policies can increase portfolio drawdowns.
Portfolio rebalancing has a much larger issue, however, one that costs investors an estimated $16 billion a year, according to my new working paper, “The Unintended Consequences of Rebalancing,” co-authored with Alessandro Melone at The Ohio State University and Michele Mazzoleni at Capital Group.
About $20 trillion in pension funds and target date funds (TDFs) are subject to fixed-target rebalancing policies. While US equity and bond markets are relatively efficient, the sheer size of these funds means rebalancing pressures move prices, even if the price impact is temporary.
Large trades should not be preannounced, but since most funds are transparent about their rebalancing policies, often their rebalancing trades are effectively public knowledge well in advance. This exposes them to front-running.
Threshold and Calendar Rebalancing
Here’s how it works. There are two main rebalancing methods: threshold and calendar.
In the latter, funds rebalance on a specific date, usually at the end of a month or quarter, and in the former, they rebalance after the portfolio breaches a certain threshold. For example, a 60-40 portfolio with a 5% percent threshold would rebalance at 55-45 if stocks were falling and at 65-35 if they were rising.
Whatever the method, rebalancing is predictable and anything predictable appeals to front-runners. They know that the rebalancing trade will involve a market-moving amount of money and that a buy order will increase prices. So, they anticipate the rebalancing and make an easy profit.
My analysis with Melone and Mazzoleni conservatively estimates that rebalancing costs add up to 8 basis points (bps) per year, or about $16 billion. So, if a fund that is rebalancing needs to buy equities and the price is $100, frontrunners will drive it up to $100.08.
Although 8 bps may strike some as nothing more than a rounding error, given how much total capital pensions and TDFs manage, that 8 bps may, in fact, exceed their annual trading costs.
Moreover, our estimate may be understating the true impact. Indeed, our paper shows that when stocks are overweight in a portfolio, at 65-35, for example, funds will sell stocks and buy bonds, leading to a 17 bps decrease in returns over the next day.
Here is another way to put it: The average pension fund or TDF investor loses $200 per year due to these rebalancing policies. That could be the equivalent of a month’s worth of contributions. Over a 24-year horizon, it could add up to two years’ worth.
Our results also indicate that this effect has strengthened over time. This makes sense. Given the rapid growth of pensions and TDFs, their trading is more likely to affect prices.
Pension Managers: “We Know about This.”
When we discovered that rebalancing costs might exceed the total transactions costs of trading, we were naturally skeptical. As a reality check, in June 2024, we presented our results to a private roundtable of senior pension managers who collectively represent about $2 trillion in assets. To our astonishment, their reaction was, “We know about this.”
We delved deeper. If you know about this, why not change your policies and reduce this cost? They told us that that they would need to go through their investment committees and the bureaucratic impediments were too steep.
One CIO who acknowledged the procedural difficulty said it was easier to “Send the signal to our alpha desk.” I paused. “Does this mean you are frontrunning your own rebalancing and other pension funds’ rebalancing?” I asked. The answer was “Yes.”
Our paper describes the magnitude of this problem. While we do not propose a specific solution, end-of-month and end-of-quarter rebalancing need to stop. Pensions should be less predictable in their rebalancing. Too much retirement money is being left on the table and then being skimmed off by front-runners.
On May 13, Alessandro and I will be discussing our paper in a webinar hosted by CFA Society United Kingdom. Join us as we identify hidden costs in traditional rebalancing strategies, explore methods to minimize market impact while maintaining disciplined asset allocation, and discuss innovative approaches to protect institutional portfolios from front-running activities.
