Optimal Rebalancing for Institutional Portfolios

Institutional fund managers generally rebalance using ad hoc methods such as calendar periods or tolerance band triggers. Another approach is to quantify the cost of a rebalancing strategy in terms of risk-adjusted returns net of transaction costs. An optimal rebalancing strategy that actively seeks to minimize that cost uses certainty-equivalents and the transaction costs associated with a policy to define a cost-to-go function. Stochastic programming is then used to minimize expected cost-to-go. Monte Carlo simulations demonstrate that the method outperforms traditional rebalancing strategies such as periodic and 5% tolerance rebalancing. TOPICS:Mutual funds/passive investing/indexing, quantitative methods, simulations