Important legal information

The content displayed on this website is exclusively directed at qualified investors, as defined in the swiss collective investment schemes act of 23 june 2006 ("cisa") and its implementing ordinance, or at “independent asset managers” which meet additional requirements as set out below. Qualified investors are in particular regulated financial intermediaries such as banks, securities dealers, fund management companies and asset managers of collective investment schemes and central banks, regulated insurance companies, public entities and retirement benefits institutions with professional treasury or companies with professional treasury.

The contents, however, are not intended for non-qualified investors. By clicking "I agree" below, you confirm and acknowledge that you act in your capacity as qualified investor pursuant to CISA or as an “independent asset manager” who meets the additional requirements set out hereafter. In the event that you are an "independent asset manager" who meets all the requirements set out in Art. 3 para. 2 let. c) CISA in conjunction with Art. 3 CISO, by clicking "I Agree" below you confirm that you will use the content of this website only for those of your clients which are qualified investors pursuant to CISA.

Representative in Switzerland of the foreign funds registered with the Swiss Financial Market Supervisory Authority ("FINMA") for distribution in or from Switzerland to non-qualified investors is Robeco Switzerland AG, Josefstrasse 218, 8005 Zürich, and the paying agent is UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zürich. Please consult for a list of FINMA registered funds.

Neither information nor any opinion expressed on the website constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service. An investment in a Robeco/Robeco Switzerland product should only be made after reading the related legal documents such as management regulations, articles of association, prospectuses, key investor information documents and annual and semi-annual reports, which can be all be obtained free of charge at this website, at the registered seat of the representative in Switzerland, as well as at the Robeco/Robeco Switzerland offices in each country where Robeco has a presence. In respect of the funds distributed in Switzerland, the place of performance and jurisdiction is the registered office of the representative in Switzerland.

This website is not directed to any person in any jurisdiction where, by reason of that person's nationality, residence or otherwise, the publication or availability of this website is prohibited. Persons in respect of whom such prohibitions apply must not access this website.

I Disagree
Is rebalancing the source of factor premiums?

Is rebalancing the source of factor premiums?

12-02-2015 | Research

Some argue that the mere mechanism of rebalancing increases returns, and that this explains the success of factor investment strategies. Although factor strategies do need rebalancing to maintain their exposures, there are several reasons why it is unlikely that this is their source of added value.

  • David Blitz
    PhD, Executive Director, Head of Quant Selection Research

Speed read

  • Factor investing requires rebalancing
  • Rebalancing is however not the source of factor premiums
  • It’s the other way around: factor premiums explain any positive returns from rebalancing

Factor investing requires rebalancing

Factor investment strategies are designed to harvest established factor premiums, such as the value, momentum or low-volatility premiums. One feature all factor investment strategies have in common is that they require periodic rebalancing, as the factor characteristics of stocks can change over time. For instance, a value strategy selects stocks that are cheap on valuation ratios such as P/E. As time goes by, however, some of these stocks may become expensive on these measures, at which point they will need to be replaced by fresh value stocks in order to maintain the factor profile of the strategy. Without rebalancing, the factor exposures of a factor investment strategy would gradually deteriorate, until no exposure at all would be left. So rebalancing is an essential aspect of factor investment strategies.

Stay informed on Quant investing with monthly mail updates
Stay informed on Quant investing with monthly mail updates

But could rebalancing even be the source of factor premiums?

The importance of rebalancing for factor investment strategies leads some to wonder whether this rebalancing mechanism could be the actual source of factor premiums. We argue, however, that this notion is incorrect, i.e. that rebalancing is not the source of factor premiums. 

Mirror-image factor portfolios rebalance just as much…and underperform

First of all, the outperformance of portfolios with attractive factor exposures is mirrored by a similar-sized underperformance of portfolios with unattractive factor exposures. If we consider for instance the value premium, studies find that the outperformance of cheap (e.g. low P/E) stocks is mirrored by a similar-sized underperformance of expensive (high P/E) stocks. Similar results are found for the momentum and low-volatility premiums. As both types of portfolios involve a similar amount of rebalancing, it is clear that factor exposures are driving their returns, and not the shared rebalancing mechanism.

‘Portfolios with unattractive factor exposures rebalance just as much as portfolios with attractive factor exposures – and still underperform’

Factors behave very differently, which argues against one underlying driver

In addition, different factors behave quite differently, have different explanations and are widely regarded as distinct phenomena. Value and momentum even have a negative correlation, as stocks with strong momentum tend to have become more expensive, while a large price decline tends to make stocks cheaper. In addition, value and momentum both have the tendency to select more risky stocks, thereby going directly against the low-volatility effect. This makes it quite unlikely that they are a manifestation of the same, shared underlying driver. 

Many factor strategies do not even need much rebalancing to begin with

Another argument is that many factor investment strategies do not need much rebalancing to begin with. Consider for example the low-volatility factor. Clearly, low-volatility strategies based on very short-term volatility measures require quite some rebalancing, but as the estimation period for past volatility is lengthened, less and less rebalancing effort is needed. A portfolio based on past 10-year volatility hardly changes from month to month, and comes pretty close to a buy-and-hold strategy.

Investors interested in harvesting the value premium do not need to engage in a lot of rebalancing either. Chow et al (2011) show that a fundamental index, which is designed to capture the value premium, only requires an annual (one-way) turnover of about 15%, meaning that positions are held, on average, for almost 7 years. Given that many factor investment strategies require so little rebalancing, it is hard to argue that it is the rebalancing mechanism which is really driving their return.

‘If there is a causal relation it is more likely to be the other way around’

Rebalancing to get back to starting weights

Besides maintaining factor exposure, rebalancing can also be done with the mere intention to bring portfolio weights back to their original values. Theoretically the impact of this type of rebalancing on return can be positive, zero or negative. After all, rebalancing can be beneficial or harmful, depending on the circumstances. As the theoretical results are inconclusive, Hallerbach (2014) conducted various empirical tests, but again the results turn out to be mixed: the rebalancing return is sometimes found to be positive and sometimes found to be negative. We can therefore conclude that rebalancing is neither theoretically nor empirically a reliable source of return. 

Turning the argument around

Rebalancing back to starting weights can induce implicit exposures to some of the classic factor premiums, as stocks which have become big, expensive or have done well are sold in favor of stocks that have become small, cheap or have done poorly. These factor exposures turn out to be able to explain most of the performance. In other words, there may indeed be a causal relation between rebalancing and factor premiums, but not in the sense that factor premiums are explained by rebalancing, but the other way around: positive returns from rebalancing may be attributed to implicitly induced exposures to classic factor premiums. 

Leave your details and download the report.

This report is not available for users from countries where the offering of foreign financial services is not permitted, such as US citizens and residents.