optimal Rebalancing for Institutional Portfolios

WtNTER 2006 I nstitutional money managers develop risk models and optimal portfolios to match a desired risk/reward profile. Utility functions express risk preferences and implicitly reflect the views of fund trustees or directors. Once a manager determines a target portfolio, maintaining this balance of assets is non-trivial. A manager must rebalance actively because different asset classes can exhibit different rates of return. JManagers also must rebalance if weights in the target portfolio are altered. This occurs when the model for expected returns of asset classes changes or the risk profile changes. Most academic theory ignores frictional costs, and assumes that a portfolio manager can simply readjust holdings dynamically without any problems. In practice, trading costs are non-zero and affect the decision to rebalance. Transaction costs involve commissions and market impact as well as cost of personnel and technological resources. If the transaction costs exceed the expected benefit fixim rebalancing, no adjustment should be made, but without any quantitative measure for this benefit, we cannot accurately determine whether or not to trade. Conventional approaches to portfolio rebalancing include periodic and tolerance band rebalancing (see Donahue and Yip |20()3] and Masters [2003]). With periodic rebalancing, the portfolio manager adjusts to the target weights at a consistent time interval (e.g., monthly or quarterly). The drawback with this method is that trading decisions are independent of market behavior.