The Economic Implications of Rebalancing

Abstract:

Trillions of dollars in pension funds and other institutional investors engage in regular portfolio rebalancing. This rebalancing often occurs based on a calendar date or a deviation from a threshold. We show that such rebalancing has a market impact and induces predictability. When stocks are overweight, funds sell stocks and buy bonds, leading to a decrease in equity returns of 17 basis points over the next day. We find our results are robust to including controls for momentum, reversals, and macroeconomic information. Importantly, mechanical rebalancing offers certain investors the opportunity to front-run the predictable trades of these large funds. We estimate that the cost of current rebalancing policies is approximately $16 billion per year—or $200 per U.S. household.