Performance Perspectives Blog

When to rebalance benchmarks

by | Apr 29, 2010

We got a call recently from someone asking how often they should rebalance their benchmark. Apparently someone within their firm is pushing for daily, but this individual was concerned with the amount of effort that would be involved.

My response was that they should ideally rebalance the benchmark when they rebalance the portfolio; to rebalance more frequently would detract from the variations which are being caused within the benchmark which would most likely vary from what they’re doing, and thus eliminate the allocation shifts which may or may not be in the manager’s favor. But to confirm my beliefs I reached out to Neil Riddles, aka “the benchmark king” to get his thoughts. He responded:

One of the important considerations for benchmarks is that they should be a passive representation of what the manager is doing in the active portfolio.
If the portfolio has a set rebalance period, then mimicking that makes sense.  For example, if it is rebalanced quarterly, then rebalancing the benchmark quarterly is best.
If the portfolio is rebalanced when it gets a certain percentage out of line, that policy should be applied to the benchmark as well.  For example, if the portfolio is rebalanced when it gets out of line by 10% (55/45) then the same rule ought to be applied to the benchmark.
Ideally, the benchmark rebalancing should not be dependent on what goes on in the portfolio.  So, if the portfolio rebalances on a non-regular schedule (or does not follow other explicit criteria) then we would not want to rebalance at the same time.  The reason is that, absent an investment in the portfolio, the investor could not achieve the benchmark results.
At any rate, rebalancing daily is likely to maximize the error introduced because the benchmark is trading costlessly.

I think our views are almost identical. Formal guidance would always be helpful, and we’ll look to develop that at some point.

p.s. I dubbed Neil “the benchmark king” quite some time ago, using the nicknames assigned to various prisoners in “The Great Escape.” For example, Steve McQueen was “the cooler king.” Oh, and if you’ve never seen the movie, you should!

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