Academic journal article Financial Services Review

Style Index Rebalancing for Better Diversification: Lessons from Broad Market and Equity Style Indexes

Academic journal article Financial Services Review

Style Index Rebalancing for Better Diversification: Lessons from Broad Market and Equity Style Indexes

Article excerpt


We explore the effectiveness of rebalancing approaches by examining the performance of both time-based and various asset-level-based triggers using equally weighted portfolios comprised of six equity style indexes. Although either form of style rebalancing attains superior performance (both absolute and risk-adjusted) over a naïve, buy-and-hold approach, we find trigger-based rebalancing results to be marginally superior. We also note that both the inability to rebalance asset allocation within a traditionally indexed equity investment fund as well as intermediate-term variability in size and style performance combine to dispel the widespread belief that investors can achieve adequate diversification solely through broad-market index holdings.

© 2009 Academy of Financial Services. All rights reserved.

JEL classification: G11; D14

Keywords: Portfolio; Diversification; Rebalancing; Asset allocation; Index & Indices

1. Introduction

Does rebalancing a portfolio truly improve its overall performance? If so, is one approach to rebalancing clearly superior to another? The answers to these questions embody the primary motivation for our research and have gained increased importance as a result of the behavior of traditional broad-market index (BMI) funds from the late 1990s through the early 2000s. During the 2000 to 2002 bear market, many investors whose portfolios tracked a BMI through open-end mutual funds or exchange-traded-funds (ETFs) learned a painful lesson when they discovered their holdings were not as well diversified as previously believed. In fact, this lack of diversification played a major role in the peak-to-trough losses of roughly 50% observed for the Standard & Poor's 500, Russell 3000 and Wilshire 5000 indexes over this period.

Great success in the technology sector during the late 1990s led to unprecedented exposure to technology stocks within the three primary BMIs, a consequence of the market capitalization-based weighting schemes they each use. For example, the S&P 500 reached a peak technology sector exposure of 34.46% of assets in August of 2000, more than triple the index's exposure to technology at the beginning of 1995. ' In other words, market cap weighting had caused more than one-third of the assets in an ostensibly well-diversified broad market index to become allocated to a single industry.

The impact of overexposure in the technology sector was virtually identical across all cap-weighted BMIs, as evidenced by the remarkable consistency of the peak-to-trough declines displayed in Panel A of Table 1. The three BMIs reached simultaneous all-time highs on March 27, 2000 and then experienced simultaneous peak-to-trough lows on October 9, 2002. Each index experienced an overall decline of 50%, with a variance of less than 95 basis points. Subsequently, these three indexes again attained simultaneous all-time highs and new peak-to-trough lows from October 9, 2007 to November 20, 2008, respectively. The performance of all three indices on this occasion was once more remarkably similar, each falling 52%, with less than 90 basis points in variation. The similarity is no coincidence. As demonstrated in Panel B of Table 1, the major BMIs have near-perfect long-term correlation. This confirms that the returns of all three are driven by the same group of very large firms, as cap-weighted indexes, rendering the impact on index performance of the smaller firms virtually inconsequential.

Among BMI choices, the S&P 500 index has long been regarded as the bellwether market proxy. Some might contend that with 3,000 and more than 7,000 stocks, respectively, the Russell 3000 and Wilshire 5000 indexes are substantially broader in scope, including a wide range of large and small cap stocks, and would therefore be better gauges of the entire equity market. That argument, however, fails to consider the effects of market-cap weighting on the stocks of smaller companies. …

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